By Steven K. Beckner
BOSTON (MNI) – Chicago Federal Reserve Bank President Charles Evans
advocated “much more” monetary stimulus Saturday and said it’s not even
“a close call.”
Evans, who will be a voting member of the Fed’s policymaking
Federal Open Market Committee in 2011, proposed that one option for the
Fed would be to announce a “price level target” in conjunction with any
decision to provide more monetary accommodation. He said such a target,
as distinct from an inflation rate target, should be made “state
contingent” for a “reasonable” time period.
Evans, in remarks prepared for a Boston Federal Reserve Bank
conference, said the economy is in a “bona fide liquidity trap” and
projected that inflation could still be a sub par 1% and unemployment 8%
or more by the end of 2012.
He pulled no punches, saying that if it was possible the federal
funds rate should be a negative 4%.
“I cannot stare at our current projections for high unemployment
and low inflation and think that these projections are consistent with
the best monetary policies to address the Fed’s dual mandate
responsibilities,” he said.
“In my opinion, much more policy accommodation is appropriate
today,” Evans said, adding that “the U.S. economy is best described as
being in a bona fide liquidity trap.”
“Risk-free short-term interest rates are essentially zero,” he
observed. “Both households and businesses have an excess of savings
relative to the new investment demands for these funds. With nominal
interest rates at zero, market clearing at lower real interest rates is
stymied.”
“In this setting, even a moderate expansion without a double dip
will not lead to appropriate labor market improvement,” he continued.
“Accordingly, highly plausible projections are 1% for core Personal
Consumption Expenditure Price Index (PCE) inflation at the end of 2012
and 8% for the unemployment rate.”
Evans said that “the Fed’s dual mandate misses are too large to
shrug off, and there is currently no policy conflict between improving
employment and inflation outcomes” and therefore “we need lower
short-term real interest rates than the current real federal funds rate
of -1 percent.”
“Indeed, if the federal funds rate were positive, I would advocate
substantial nominal reductions,” he added. “But we are effectively at
zero.”
He said “typical linear Taylor rules” suggest a “minus 4 percent”
funds rate is needed and “would boost aggregate demand enough to deliver
substantially lower unemployment by the end of 2012.”
“If you reach the conclusion that we are in a liquidity trap, or
even near a perilous liquidity trap, more accommodation is not
data-dependent or a close call,” he said.
Evans refrained from saying exactly how or when the Fed should
increase accomodation, but made some suggestions.
“If the Federal Reserve decided to increase the degree of policy
accommodation today, two avenues could be: 1) additional large-scale
asset purchases, and 2) a communication that policy rates will remain at
zero for longer than ‘an extended period.'”
“A third and complementary policy tool would be to announce that,
given the current liquidity trap conditions, monetary policy would seek
to target a path for the price level,” he continued. “Simply stated, a
price-level target is a path for the price level that the central bank
should strive to hit within a reasonable period of time.”
For example, he said, “if the slope of the price path … is 2% and
inflation has been underrunning the path for some time, monetary policy
would strive to catch up to the path: Inflation would be higher than 2%
for a time until the path was reattained.”
Evans referred to this as “a state-contingent policy because the
price-level targeting regime is only intended for the duration of the
liquidity trap episode.”
Evans said he is “hopeful for this policy’s potential to improve
upon our current liquidity trap economic conditions.”
He imagined how a price level target would work in various
scenarios, first an optimstic one in which inflation returns to 2% or
more and the “price gap” is closed by the end of 2012.
In that situation, he said, “Many questions regarding operational
responses during this adjustment would need to be addressed.”
“If short-term interest rates remain near zero during this
adjustment, real interest rates would be between -2 and -3 percent,” he
said. “Perhaps that would be enough to improve labor markets and
aggregate demand sufficiently, but I personally put more faith in
analyses that suggest the liquidity trap is larger than this.”
Evans said that “in this scenario at the end of 2012, if resource
slack remains substantial and inflationary pressures are returning
toward 2% over the medium term on account of credible policy commitment,
then a standard Taylor-rule prescription may still call for a relatively
low federal funds rate.”
“And the size and composition of the Fed’s balance sheet might also
be consistent with accommodation,” he continued.
Other situations might “require more complicated responses,” he
said.
For example, he said it is possible that “inflation continues to
remain very low even after an announcement that monetary policy is
following a price-level path. As inflation delay continues, the
‘inflation deficit’ account builds. That is, the price gap gets larger,
and implied future inflation to attain the (targeted price) path grows.”
Evans said that “would clearly be nerve-wracking for policymakers,
and the credibility of our commitment to ever growing inflation rates
would be crucial for the success of the policy.”
But he said “if our resolve is credible, well-functioning financial
markets should get the message.” He added that he “would expect the
financial press to help communicate these investment risks on a regular
basis.”
Evans said another challenge might come if “the degree of resource
slack in the economy is much smaller than many presume, for example if
the structural rate of unemployment was upward of 8%.
“In this case, more accommodation could lead to higher inflation
and a rapid closing of the price gap,” he said. “A quicker closing of
the price gap harkens the exit of the state-contingent price-level
policy.”
“The fact that unemployment would remain high would be a signal
that increasing aggregate demand alone is not enough to address this
problem,” he went on. “But monetary policy would have succeeded in
moving closer to price stability with the attending benefits from
achieving that policy goal.”
Another possible scenario addressed by Evans is “if inflation was
surprisingly high at the point when the price gap was eliminated and
policy reverted to targeting 2% inflation over the medium term.”
He called that “extremely unlikely,” but “in the unlikely
occurrence that inflation accelerates beyond the levels we anticipate,
we have the tools to deal with it.”
“Specifically, relative to initial baseline scenarios, the Fed
could more aggressively increase the federal funds rate and interest on
excess reserves (IOER), as well as drain liquidity from our balance
sheet,” he said. “Furthermore, any higher inflation would almost surely
be associated with stronger economic growth and job creation, so these
stronger ‘exit strategy’ actions would be entirely appropriate.”
If the Fed were to adopt a price level target, he said it “would
have to credibly convey to the public that this policy will end when the
price gap is closed.”
He warned that “an important risk would be the temptation to keep
policy easy if the labor market has not reached the vicinity of full
employment.”
** Market News International **
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