Remarks by Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago
University of Chicago Graduate School of Business
Chicago, IL
October 22, 2007
Current Economic Outlook*
Introduction
It really is a pleasure for me to be here at an event cosponsored by the University of Chicago's Graduate School of Business and the Chicago Council on Global Affairs. The Federal Reserve Bank of Chicago has benefited greatly from so many of the relationships it has established over the years with the GSB and the Council. Working together with the academic, business, and policy communities of this city, we have been able to address important economic issues at forums like this one. My being here tonight is an excellent example of just that, and I am delighted to have this venue serve as my first public speaking event since becoming President and CEO of the Chicago Fed on September 1.
I would like to emphasize that my comments today are my views and not necessarily those of my colleagues on the Federal Open Market Committee.
Though I have been President for only two months, I have had the remarkably useful experience of attending FOMC meetings since 1995 — first as a senior staffer and since 2003 as the Bank's Research Director. Over these past 12 years, I have observed the Committee make policy during a variety of interesting and challenging economic and financial periods. And most of my research career has involved studying monetary policy decision-making and its effects on the economy. Indeed, I first met then Professor Ben Bernanke at a research conference where we both presented papers on monetary economics. It shouldn't come as a surprise to anyone that I expect to draw on these experiences in my participation at FOMC meetings.
Since this is my first speech as President, I will first take some time to provide background on how I approach the analysis of monetary policy decision-making. I will then discuss current economic conditions.
Putting the Current Policy Decision in a Broader Context
Over the past 10 years we have witnessed a number of very different kinds of developments and shocks to the economy — the acceleration in worker productivity, the emerging market debt crises in 1997-98, the high-tech boom and bust at the turn of the century, and the tragic events of September 11, to name a few. Seeing the Committee make decisions when faced with such events emphasized to me that no matter how unique or uncertain the situation may seem, it is important to view the current policy decision in the broader context of our efforts to achieve maximum employment and price stability. These, of course, are the dual mandates of the Federal Reserve when conducting monetary policy for the United States.
Let me take a few moments to discuss how I go about putting policy decisions into this broader perspective. Specifically, I'd like to talk about three kinds of considerations that I think are always important for coming to a sound policy decision. The first is the most obvious: our need to assess the general condition of the economy—both in terms of its underlying structure and its current cyclical performance. Such an assessment helps us to understand how the particular events we are experiencing will work their way through the economic system to influence growth and inflation over the coming quarters and years. The second set of considerations concerns the stance of monetary policy. Specifically, it's always important to ask where the federal funds rate stands relative to some concept of a neutral rate and how the resulting degree of accommodation or restriction will influence the achievement of our dual mandate. The final category of considerations has to do with the degree of uncertainty that we face with regard to both the state of the economy and the effects of policy. At times we may need to adopt a risk management approach to policy—that is, adjust the stance of policy to guard against the risk of events that may not be in our baseline projection but, if they did occur, would present an especially notable threat to sustainable growth or price stability. Often such policy adjustments can be described as pre-emptive, in the sense that they reduce the odds of the more adverse outcome occurring.
1. The Structure of the Economy
The first issue deals with initial economic conditions and the dynamic structure of the U.S. economy. When the economic climate shifts and policy is adjusted, the ultimate effect on output and inflation depends on how various economic players and markets work and interact with one another, how prices adjust to re-direct resources, the rate at which technology progresses, and a myriad of other structural characteristics of the economy. The influence of an unexpected shock also depends on how shorter-term cyclical conditions compare with our policy goals; that is, how much resource slack is present in the economy and where the outlook for inflation is relative to price stability. Our broader policy analysis has to account for both the structural and cyclical factors.
One longer-run structural feature to consider is the fact that since the mid-1980s fluctuations in aggregate output have been a good deal smaller than they were earlier in the post-war period. Recessions have been less severe, there has been less commonality in fluctuations across industries, and inflation has been lower and less volatile. The U.S. has been in what economists refer to as "The Great Moderation." We do not have a complete explanation for what caused the Great Moderation. Some research points to smaller shocks, suggesting the U.S. economy has enjoyed a bit of good fortune. Other studies emphasize improved control over inventories, and some analyses give a role to financial market innovations that allow for more efficient allocation of financing and better risk sharing. These and other such structural developments suggest that the economy's natural shock absorbers may operate better today, supporting the conclusion that the U.S. economy has become more resilient. Accordingly, the outlook on which we base our policy decision should account for the likelihood that a given economic event might result in smaller and less persistent fluctuations in output and inflation.
There also is an interplay between the reaction of policy to events, the increased resiliency of the economy, and where we stand relative to our policy goals. Let me give you a couple of historical examples. Think about the oil shocks in the 1970s. These hit when inflation pressures already had been rising. Furthermore, around the same time there had been a decline in the rate of sustainable economic growth. This change and its inflationary implications were not well recognized at the time. Looking back, we think now that part of the slower growth reflected inflexibilities that made it difficult for many industries to adjust to higher energy prices. The ultimate outcome was a deep recession in 1973-75 and soaring inflation. Eventually, the Volcker Fed had to implement highly restrictive and costly policies to bring inflation down. In contrast, when oil prices began increasing in 2004, core PCE inflation was just 1-1/2 percent, the underlying trend in productivity was relatively solid, and the energy efficiency of the economy was much better than during the 1970s. One reason the economy performed better is that the shock was smaller. But it also is the case that the shock hit a more flexible economy that was performing well. Together, these meant that overall growth was better maintained and only a modest policy adjustment was necessary to check the pass-through of energy costs to the trend in inflation.
2. Where Policy Stands Relative to a Neutral Rate
Now let's turn to the second issue — assessing the stance of policy. At any particular FOMC meeting, after reviewing the economic and financial situation, the discussion turns to the policy decision. For me, this requires focusing on longer-run benchmarks, in particular, where the current fed funds rate is relative to a conceptual, neutral setting for policy. By a neutral funds rate, I mean the rate that is consistent with an economy operating along its potential growth path and with stable inflation. I will readily admit that there is a great deal of uncertainty about measuring this neutral rate. Still, with appropriate caveats, the neutral fed funds rate is a useful benchmark. One reason why John Taylor's research on monetary policy rules has been so useful is because the Taylor rule casts the prescriptions for the funds rate against such a benchmark. Rates above neutral tend to restrict aggregate demand, and rates below neutral are accommodative. At any point in time, if we simply look at the decision to raise, lower, or leave unchanged the fed funds rate, then we lose perspective on the overall stance of policy. This is a relatively obvious point, but one that bears emphasizing: Hypothetically, when policymakers raise the funds rate and it remains below the neutral rate, then, on net, policy still is accommodative. Indeed, this was the case in late 2004 and 2005.
There are a number of determinants of the neutral rate. One important determinant is productivity. With higher productivity growth, the return to investment is higher, and a higher neutral interest rate is necessary to equilibrate capital market flows and aggregate demand and supply. Another key determinant is the expected inflation rate. In order to induce savers to forego consumption, they must be compensated for any loss in purchasing power over time due to rising prices. So a higher expected inflation rate translates into a higher neutral federal funds rate.
This brief description is obviously not complete. First, we do not have an exact estimate of the neutral rate. It depends on factors that we cannot observe directly — for example, the structural long-run trend in the rate of productivity growth and inflation expectations. We thus turn to statistical estimates and indirect measures, which by their very nature are imprecise. Second, the neutral rate can change over time as its components change, and it is often difficult to ascertain these movements until well after the fact. Consider, for example, how hard it was to discern the permanence of the productivity increase in the second half of the 1990s. Third, the degree of accommodation represented by the gap between the actual and neutral funds rate is only one factor affecting the amount of liquidity that is ultimately influencing economic activity and inflation. Other financial circumstances can work to offset or exaggerate the impulse from policy, and these can change dramatically over time—as we have witnessed recently with the swing in credit market conditions. And, as if this wasn’t tough enough, quantifying the net impact of financial conditions on the economy is technically challenging.
3. Acknowledging Uncertainties
These caveats about the neutral fed funds rate and the stance of policy also relate to the third element of my broader view towards policy; that is, the importance of recognizing and respecting the uncertainty and related risks we face when making policy decisions. This uncertainty is large. Indeed, it is somewhat amusing how often we are tempted to say that things are more uncertain today than they usually are. Well, if we think this so often, it can't be very unusual. A myriad of factors can and do regularly generate substantial uncertainties about the outlook for the economy — think of the list I gave earlier: the productivity acceleration, the emerging market debt crisis, the high-tech boom and bust, and September 11 and its aftermath. So a key aspect of policymaking is understanding when uncertainties are especially large, identifying associated risks to the forecast, and assessing the implications of these risks for achieving price stability and maximum sustainable growth.
Some risks relate to possible events or extreme macroeconomic outcomes that are not very likely to occur, but whose cost in terms of output or inflation could be quite large. In such cases, it is prudent to adjust policy to be more or less accommodative than we otherwise would as insurance against the highly adverse outcome. These are the risk management or pre-emptive views of policy I mentioned earlier, and they are a common component in central bankers' strategies. But if the extreme event does not occur or its influence subsides quickly, then it is incumbent upon policymakers to recalibrate policy — and to do so from a baseline that accounts for how the additional insurance put into the system affects the outlook for growth and inflation.
A different, and more typical, set of risks relates to where our forecast stands relative to our longer-run policy goals — for example, whether growth will be significantly above or below its sustainable rate and whether inflation will be too high or too low. And it is interesting that we are finally operating in a world with two-sided inflation risks — we thought it was too high in early 2007 at 2-1/2 percent, but that it is was too low in 2003 when, according to the data published at the time, it fell below 1 percent.
Background for the Current Outlook
Now that I have provided some background for how I approach monetary policy issues, I will turn to the current outlook and policy situation. In doing so, I will discuss it in terms of the structural and cyclical characteristics of the economy, the stance of policy relative to neutrality, and the uncertainties we are facing in the policy decision.
A good place to start the discussion is with the situation at midyear before the recent disruptions in credit markets. At the Chicago Fed, we expected that the contraction in residential construction would likely restrain overall activity for a while longer, but that this restraint would abate as we moved through next year. Indeed, outside of housing, the economy has been performing fairly well: Over the previous year and a half, declines in residential investment reduced real GDP growth by about 3/4 percentage point, but the rest of the economy increased at a solid 3-1/4 percent rate. Overall, we were expecting average GDP growth in the second half of 2007 to be somewhat below potential — which we then thought was just slightly under 3 percent — but that growth would return to potential as we moved through 2008.
Our June projection looked for the unemployment rate to rise from 4-1/2 to 4-3/4 percent by the end of 2008. Of course, 4-3/4 percent is a historically low value for the unemployment rate. This and other evidence suggested some risk of resource pressures showing through to inflation. Indeed, while core inflation had come down from early in the year, we were concerned that some of that drop might prove to be transitory. As a result, our June forecast was for core inflation to run around 2 percent — about the same as its pace over the previous year, but higher than the rate we had seen in the more recent months.
At the time, the funds rate was 5-1/4 percent, and market participants were expecting little change in the rate over the projection period. Back in June, a 5-1/4 percent funds rate probably was a bit above what I considered neutral. Although, given the caveats I discussed earlier, there was a healthy dose of uncertainly around this assessment. In my opinion, this restrictive stance for policy attempted to balance several factors. Importantly, financing conditions for most firms were still highly favorable. Notably, most risk premia remained quite low and many buyout deals were being done without typical loan covenants and other forms of credit protection. So there was a risk that these factors made overall financial conditions more accommodative than suggested by the funds rate alone. When combined with the risk to inflation from resource pressures, this suggested to me that a slightly restrictive funds rate was useful to mitigate potential inflationary risks.
However, as events unfolded in July, before the August turmoil in the credit markets, new information pointed to a reduction in the neutral fed funds rate, which meant that the stance of policy had become more restrictive.
The first factor lowering the equilibrium funds rate had to do with information revealed with the annual revisions to the national income accounts that were released in late July. These revisions included lower estimates for GDP. These helped reduce uncertainty about an important question — namely, the possibility that there had been some decline in the underlying trend growth in productivity since the first half of the decade. This factor also tends to signal higher unit labor costs and inflationary pressures. However, on balance, we in Chicago were impressed that the improvements in core inflation that we had seen earlier in the year seemed to be more persistent than we had initially thought. This caused us to adjust down our forecast for inflation in 2008-09. The lower estimate for trend productivity growth and the lower inflation forecast both pointed to a somewhat lower neutral funds rate. Hence, these factors suggested that the stance of policy was more restrictive than I believed in June.
The Financial Turmoil of August
Then came the financial turmoil in August. In light of the substantial increase in default rates on sub-prime mortgages, market participants substantially reduced the perceived value of all kinds of debt instruments backed by subprime mortgages. The resulting losses on balance sheets greatly reduced the amount of leverage that could be supported by these assets, and a period of de-leveraging began. In addition, market participants began to question the value of other complex securities. And, in general, many borrowers had to turn to shorter-term financing as lenders were unwilling to commit funds at term because of uncertainty over the valuation of collateral, potential needs for liquidity, and counterparty risks. Liquidity became scarce — as evidenced, for example, by large increases in spreads between overnight and term financing rates.
It is important to remember, however, that many financial markets have continued functioning without any problems. Highly rated corporate borrowers have had little trouble issuing bonds at favorable rates, and banks continue to lend to sound businesses. Indeed, although the cost of funding to some borrowers might be higher, we have not heard widespread reports of businesses being unable to finance working capital or longer-run capital expenditures.
Nevertheless, financial conditions in private credit markets are clearly more restrictive than they were a couple of months ago. In my opinion, it was no longer appropriate for monetary policy to include a slight degree of policy restraint to lean against the risks posed by low risk-pricing in financial markets. Those risks had receded. And, importantly, they had done so against the backdrop of a more favorable inflation outlook and a lower neutral rate.
Uncertainty and Risk Management in the Current Environment
As I mentioned at the start of my talk, policymakers need to take account of the uncertainty that they face and tailor policy in a way to best manage the risks to sustainable growth and price stability imposed by those uncertainties.
The gyrations in financial markets add a number of uncertainties to the outlook. Currently, market participants are in the process of reassessing credit exposures and establishing new risk pricing standards. There is uncertainty regarding how long this process will last and where it might take us. Indeed, developments in the last week reinforce this. Many market participants did not have a good idea of the credit risk associated with the opaque assets that they had purchased. For example, some investors may have assumed that a triple-A tranche of a sub-prime mortgage-backed security carried little default risk. They now know this assumption was wrong. This affects both how investors value their own books and how they assess the repayment abilities of counterparties who have been holding such assets to finance future transactions. So firms must now sift through their books and reassess the risks associated with the securities they are holding. This process is not easy: In some cases the instruments are quite complex, making it hard to identify the riskiness of the actual cash flows supporting the securities.
Ultimately, with more diligent and improved risk assessments, price discovery will go forward. The market mechanism will produce new prices at which participants are willing to trade risky assets. Continued improvements in trading will occur, albeit at values that more appropriately reflect the underlying credit and counterparty risks. But what the path to this new risk pricing will look like is still uncertain.
Another uncertainty surrounds the impact of the change in credit conditions on real economic activity. Some firms likely are facing higher costs and less favorable terms. At least to date, however, we do not seem to be seeing an impact on capital spending. Similarly, consumer credit conditions have not changed much in response to the financial turmoil. But the demand for housing has been further reduced because the inability to securitize non-conforming mortgages has contributed to a large cutback in such originations, particularly for sub-prime loans.
To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. Under one scenario, the effects on overall growth will be fairly isolated to declines in residential construction — similar to our experience in 2006 and early 2007. However, there is a less benign possibility. Housing demand and prices could weaken a good deal more than we expect — either because a new shock hits the sector or because we have underestimated the weakness already in train. A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth.
I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against. The challenge is to calibrate the insurance in light of the lower probability of the spillover event occurring. Furthermore, if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook.
Indeed, not all of the risks to the economic outlook are on the downside. The effects of financial difficulties on real activity are hard to predict. For example, recall 1998, when concerns about the fallout of the Russian default on other emerging market debt and the difficulties related to LTCM led to a freezing of activity in certain financial markets. Despite all of the concerns about how this might affect economic activity, in 1999 real GDP ended up growing 4.7 percent and significant resource pressures emerged.
Returning to the current situation, the process of assessing credit exposure appears to be well underway and a number of large financial institutions already have reported losses on their books. There is also some evidence suggesting that investors are more willing to differentiate between commercial paper issuers based on the quality of the underlying assets. Markets also have become somewhat more receptive to high-yield issues and to term lending. In addition, term premia in markets where liquidity was impaired have come down, though they remain above levels that prevailed in late July. There still is a way to go. Improvements are not uniform, and risks remain. However, markets are functioning better than they were two months ago.
The Outlook and the Policy Picture Going Forward
Putting all of this information together, our baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy.
Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast. True, housing markets have tumbled further — sales fell sharply in August, new construction dropped a good deal further in August and September, and prices have softened. But the rest of the economy appears to be moving forward. Sales at automotive dealers and other retailers posted good numbers (in real terms) in August and September, indicators point to further increases in business investment, and industrial production has continued to rise. Importantly, according to the revised data, nonfarm payrolls increased an average of about a 100,000 per month rate in August and September — a pace we think is in line with demographic trends and an economy growing at potential.
With regard to inflation, we do not see any large movement one way or the other from current levels of core price inflation. Here the risks seem two-sided. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to mitigate the potential for this.
The latest numbers on inflation have been positive. The 12-month change in core PCE prices remained at 1-3/4 percent in August. We do not have the PCE index for September yet, but the CPI data for September that were released last week showed a moderate increase in core prices. At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09. Relative to our outlook six months ago, this is a favorable development.
Conclusion
Looking ahead, we will need to monitor developments regarding the outlook for both growth and inflation quite carefully. We will have our eyes open for the downside risks that I mentioned earlier. Events also could transpire that cause us to boost our growth projection. In addition, we cannot afford to be lax on the inflation front. Although I am optimistic about the chances for further inflation improvements, I would see any increase in inflation or inflation expectations from their current levels as a serious concern.
Over time, the current set of uncertainties and risks will fade. However, others will take their place — some will appear to be new and unique, and some we will have faced before. In any event, my views on monetary policy will depend on my outlook for the economy, the risks and uncertainties embedded in the forecast, and how these relate to the achievement of the Federal Reserve's dual mandate for maximum sustainable growth and price stability.
*The views presented here are my own and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.
President and Chief Executive Officer
Federal Reserve Bank of Chicago
University of Chicago Graduate School of Business
Chicago, IL
October 22, 2007
Current Economic Outlook*
Introduction
It really is a pleasure for me to be here at an event cosponsored by the University of Chicago's Graduate School of Business and the Chicago Council on Global Affairs. The Federal Reserve Bank of Chicago has benefited greatly from so many of the relationships it has established over the years with the GSB and the Council. Working together with the academic, business, and policy communities of this city, we have been able to address important economic issues at forums like this one. My being here tonight is an excellent example of just that, and I am delighted to have this venue serve as my first public speaking event since becoming President and CEO of the Chicago Fed on September 1.
I would like to emphasize that my comments today are my views and not necessarily those of my colleagues on the Federal Open Market Committee.
Though I have been President for only two months, I have had the remarkably useful experience of attending FOMC meetings since 1995 — first as a senior staffer and since 2003 as the Bank's Research Director. Over these past 12 years, I have observed the Committee make policy during a variety of interesting and challenging economic and financial periods. And most of my research career has involved studying monetary policy decision-making and its effects on the economy. Indeed, I first met then Professor Ben Bernanke at a research conference where we both presented papers on monetary economics. It shouldn't come as a surprise to anyone that I expect to draw on these experiences in my participation at FOMC meetings.
Since this is my first speech as President, I will first take some time to provide background on how I approach the analysis of monetary policy decision-making. I will then discuss current economic conditions.
Putting the Current Policy Decision in a Broader Context
Over the past 10 years we have witnessed a number of very different kinds of developments and shocks to the economy — the acceleration in worker productivity, the emerging market debt crises in 1997-98, the high-tech boom and bust at the turn of the century, and the tragic events of September 11, to name a few. Seeing the Committee make decisions when faced with such events emphasized to me that no matter how unique or uncertain the situation may seem, it is important to view the current policy decision in the broader context of our efforts to achieve maximum employment and price stability. These, of course, are the dual mandates of the Federal Reserve when conducting monetary policy for the United States.
Let me take a few moments to discuss how I go about putting policy decisions into this broader perspective. Specifically, I'd like to talk about three kinds of considerations that I think are always important for coming to a sound policy decision. The first is the most obvious: our need to assess the general condition of the economy—both in terms of its underlying structure and its current cyclical performance. Such an assessment helps us to understand how the particular events we are experiencing will work their way through the economic system to influence growth and inflation over the coming quarters and years. The second set of considerations concerns the stance of monetary policy. Specifically, it's always important to ask where the federal funds rate stands relative to some concept of a neutral rate and how the resulting degree of accommodation or restriction will influence the achievement of our dual mandate. The final category of considerations has to do with the degree of uncertainty that we face with regard to both the state of the economy and the effects of policy. At times we may need to adopt a risk management approach to policy—that is, adjust the stance of policy to guard against the risk of events that may not be in our baseline projection but, if they did occur, would present an especially notable threat to sustainable growth or price stability. Often such policy adjustments can be described as pre-emptive, in the sense that they reduce the odds of the more adverse outcome occurring.
1. The Structure of the Economy
The first issue deals with initial economic conditions and the dynamic structure of the U.S. economy. When the economic climate shifts and policy is adjusted, the ultimate effect on output and inflation depends on how various economic players and markets work and interact with one another, how prices adjust to re-direct resources, the rate at which technology progresses, and a myriad of other structural characteristics of the economy. The influence of an unexpected shock also depends on how shorter-term cyclical conditions compare with our policy goals; that is, how much resource slack is present in the economy and where the outlook for inflation is relative to price stability. Our broader policy analysis has to account for both the structural and cyclical factors.
One longer-run structural feature to consider is the fact that since the mid-1980s fluctuations in aggregate output have been a good deal smaller than they were earlier in the post-war period. Recessions have been less severe, there has been less commonality in fluctuations across industries, and inflation has been lower and less volatile. The U.S. has been in what economists refer to as "The Great Moderation." We do not have a complete explanation for what caused the Great Moderation. Some research points to smaller shocks, suggesting the U.S. economy has enjoyed a bit of good fortune. Other studies emphasize improved control over inventories, and some analyses give a role to financial market innovations that allow for more efficient allocation of financing and better risk sharing. These and other such structural developments suggest that the economy's natural shock absorbers may operate better today, supporting the conclusion that the U.S. economy has become more resilient. Accordingly, the outlook on which we base our policy decision should account for the likelihood that a given economic event might result in smaller and less persistent fluctuations in output and inflation.
There also is an interplay between the reaction of policy to events, the increased resiliency of the economy, and where we stand relative to our policy goals. Let me give you a couple of historical examples. Think about the oil shocks in the 1970s. These hit when inflation pressures already had been rising. Furthermore, around the same time there had been a decline in the rate of sustainable economic growth. This change and its inflationary implications were not well recognized at the time. Looking back, we think now that part of the slower growth reflected inflexibilities that made it difficult for many industries to adjust to higher energy prices. The ultimate outcome was a deep recession in 1973-75 and soaring inflation. Eventually, the Volcker Fed had to implement highly restrictive and costly policies to bring inflation down. In contrast, when oil prices began increasing in 2004, core PCE inflation was just 1-1/2 percent, the underlying trend in productivity was relatively solid, and the energy efficiency of the economy was much better than during the 1970s. One reason the economy performed better is that the shock was smaller. But it also is the case that the shock hit a more flexible economy that was performing well. Together, these meant that overall growth was better maintained and only a modest policy adjustment was necessary to check the pass-through of energy costs to the trend in inflation.
2. Where Policy Stands Relative to a Neutral Rate
Now let's turn to the second issue — assessing the stance of policy. At any particular FOMC meeting, after reviewing the economic and financial situation, the discussion turns to the policy decision. For me, this requires focusing on longer-run benchmarks, in particular, where the current fed funds rate is relative to a conceptual, neutral setting for policy. By a neutral funds rate, I mean the rate that is consistent with an economy operating along its potential growth path and with stable inflation. I will readily admit that there is a great deal of uncertainty about measuring this neutral rate. Still, with appropriate caveats, the neutral fed funds rate is a useful benchmark. One reason why John Taylor's research on monetary policy rules has been so useful is because the Taylor rule casts the prescriptions for the funds rate against such a benchmark. Rates above neutral tend to restrict aggregate demand, and rates below neutral are accommodative. At any point in time, if we simply look at the decision to raise, lower, or leave unchanged the fed funds rate, then we lose perspective on the overall stance of policy. This is a relatively obvious point, but one that bears emphasizing: Hypothetically, when policymakers raise the funds rate and it remains below the neutral rate, then, on net, policy still is accommodative. Indeed, this was the case in late 2004 and 2005.
There are a number of determinants of the neutral rate. One important determinant is productivity. With higher productivity growth, the return to investment is higher, and a higher neutral interest rate is necessary to equilibrate capital market flows and aggregate demand and supply. Another key determinant is the expected inflation rate. In order to induce savers to forego consumption, they must be compensated for any loss in purchasing power over time due to rising prices. So a higher expected inflation rate translates into a higher neutral federal funds rate.
This brief description is obviously not complete. First, we do not have an exact estimate of the neutral rate. It depends on factors that we cannot observe directly — for example, the structural long-run trend in the rate of productivity growth and inflation expectations. We thus turn to statistical estimates and indirect measures, which by their very nature are imprecise. Second, the neutral rate can change over time as its components change, and it is often difficult to ascertain these movements until well after the fact. Consider, for example, how hard it was to discern the permanence of the productivity increase in the second half of the 1990s. Third, the degree of accommodation represented by the gap between the actual and neutral funds rate is only one factor affecting the amount of liquidity that is ultimately influencing economic activity and inflation. Other financial circumstances can work to offset or exaggerate the impulse from policy, and these can change dramatically over time—as we have witnessed recently with the swing in credit market conditions. And, as if this wasn’t tough enough, quantifying the net impact of financial conditions on the economy is technically challenging.
3. Acknowledging Uncertainties
These caveats about the neutral fed funds rate and the stance of policy also relate to the third element of my broader view towards policy; that is, the importance of recognizing and respecting the uncertainty and related risks we face when making policy decisions. This uncertainty is large. Indeed, it is somewhat amusing how often we are tempted to say that things are more uncertain today than they usually are. Well, if we think this so often, it can't be very unusual. A myriad of factors can and do regularly generate substantial uncertainties about the outlook for the economy — think of the list I gave earlier: the productivity acceleration, the emerging market debt crisis, the high-tech boom and bust, and September 11 and its aftermath. So a key aspect of policymaking is understanding when uncertainties are especially large, identifying associated risks to the forecast, and assessing the implications of these risks for achieving price stability and maximum sustainable growth.
Some risks relate to possible events or extreme macroeconomic outcomes that are not very likely to occur, but whose cost in terms of output or inflation could be quite large. In such cases, it is prudent to adjust policy to be more or less accommodative than we otherwise would as insurance against the highly adverse outcome. These are the risk management or pre-emptive views of policy I mentioned earlier, and they are a common component in central bankers' strategies. But if the extreme event does not occur or its influence subsides quickly, then it is incumbent upon policymakers to recalibrate policy — and to do so from a baseline that accounts for how the additional insurance put into the system affects the outlook for growth and inflation.
A different, and more typical, set of risks relates to where our forecast stands relative to our longer-run policy goals — for example, whether growth will be significantly above or below its sustainable rate and whether inflation will be too high or too low. And it is interesting that we are finally operating in a world with two-sided inflation risks — we thought it was too high in early 2007 at 2-1/2 percent, but that it is was too low in 2003 when, according to the data published at the time, it fell below 1 percent.
Background for the Current Outlook
Now that I have provided some background for how I approach monetary policy issues, I will turn to the current outlook and policy situation. In doing so, I will discuss it in terms of the structural and cyclical characteristics of the economy, the stance of policy relative to neutrality, and the uncertainties we are facing in the policy decision.
A good place to start the discussion is with the situation at midyear before the recent disruptions in credit markets. At the Chicago Fed, we expected that the contraction in residential construction would likely restrain overall activity for a while longer, but that this restraint would abate as we moved through next year. Indeed, outside of housing, the economy has been performing fairly well: Over the previous year and a half, declines in residential investment reduced real GDP growth by about 3/4 percentage point, but the rest of the economy increased at a solid 3-1/4 percent rate. Overall, we were expecting average GDP growth in the second half of 2007 to be somewhat below potential — which we then thought was just slightly under 3 percent — but that growth would return to potential as we moved through 2008.
Our June projection looked for the unemployment rate to rise from 4-1/2 to 4-3/4 percent by the end of 2008. Of course, 4-3/4 percent is a historically low value for the unemployment rate. This and other evidence suggested some risk of resource pressures showing through to inflation. Indeed, while core inflation had come down from early in the year, we were concerned that some of that drop might prove to be transitory. As a result, our June forecast was for core inflation to run around 2 percent — about the same as its pace over the previous year, but higher than the rate we had seen in the more recent months.
At the time, the funds rate was 5-1/4 percent, and market participants were expecting little change in the rate over the projection period. Back in June, a 5-1/4 percent funds rate probably was a bit above what I considered neutral. Although, given the caveats I discussed earlier, there was a healthy dose of uncertainly around this assessment. In my opinion, this restrictive stance for policy attempted to balance several factors. Importantly, financing conditions for most firms were still highly favorable. Notably, most risk premia remained quite low and many buyout deals were being done without typical loan covenants and other forms of credit protection. So there was a risk that these factors made overall financial conditions more accommodative than suggested by the funds rate alone. When combined with the risk to inflation from resource pressures, this suggested to me that a slightly restrictive funds rate was useful to mitigate potential inflationary risks.
However, as events unfolded in July, before the August turmoil in the credit markets, new information pointed to a reduction in the neutral fed funds rate, which meant that the stance of policy had become more restrictive.
The first factor lowering the equilibrium funds rate had to do with information revealed with the annual revisions to the national income accounts that were released in late July. These revisions included lower estimates for GDP. These helped reduce uncertainty about an important question — namely, the possibility that there had been some decline in the underlying trend growth in productivity since the first half of the decade. This factor also tends to signal higher unit labor costs and inflationary pressures. However, on balance, we in Chicago were impressed that the improvements in core inflation that we had seen earlier in the year seemed to be more persistent than we had initially thought. This caused us to adjust down our forecast for inflation in 2008-09. The lower estimate for trend productivity growth and the lower inflation forecast both pointed to a somewhat lower neutral funds rate. Hence, these factors suggested that the stance of policy was more restrictive than I believed in June.
The Financial Turmoil of August
Then came the financial turmoil in August. In light of the substantial increase in default rates on sub-prime mortgages, market participants substantially reduced the perceived value of all kinds of debt instruments backed by subprime mortgages. The resulting losses on balance sheets greatly reduced the amount of leverage that could be supported by these assets, and a period of de-leveraging began. In addition, market participants began to question the value of other complex securities. And, in general, many borrowers had to turn to shorter-term financing as lenders were unwilling to commit funds at term because of uncertainty over the valuation of collateral, potential needs for liquidity, and counterparty risks. Liquidity became scarce — as evidenced, for example, by large increases in spreads between overnight and term financing rates.
It is important to remember, however, that many financial markets have continued functioning without any problems. Highly rated corporate borrowers have had little trouble issuing bonds at favorable rates, and banks continue to lend to sound businesses. Indeed, although the cost of funding to some borrowers might be higher, we have not heard widespread reports of businesses being unable to finance working capital or longer-run capital expenditures.
Nevertheless, financial conditions in private credit markets are clearly more restrictive than they were a couple of months ago. In my opinion, it was no longer appropriate for monetary policy to include a slight degree of policy restraint to lean against the risks posed by low risk-pricing in financial markets. Those risks had receded. And, importantly, they had done so against the backdrop of a more favorable inflation outlook and a lower neutral rate.
Uncertainty and Risk Management in the Current Environment
As I mentioned at the start of my talk, policymakers need to take account of the uncertainty that they face and tailor policy in a way to best manage the risks to sustainable growth and price stability imposed by those uncertainties.
The gyrations in financial markets add a number of uncertainties to the outlook. Currently, market participants are in the process of reassessing credit exposures and establishing new risk pricing standards. There is uncertainty regarding how long this process will last and where it might take us. Indeed, developments in the last week reinforce this. Many market participants did not have a good idea of the credit risk associated with the opaque assets that they had purchased. For example, some investors may have assumed that a triple-A tranche of a sub-prime mortgage-backed security carried little default risk. They now know this assumption was wrong. This affects both how investors value their own books and how they assess the repayment abilities of counterparties who have been holding such assets to finance future transactions. So firms must now sift through their books and reassess the risks associated with the securities they are holding. This process is not easy: In some cases the instruments are quite complex, making it hard to identify the riskiness of the actual cash flows supporting the securities.
Ultimately, with more diligent and improved risk assessments, price discovery will go forward. The market mechanism will produce new prices at which participants are willing to trade risky assets. Continued improvements in trading will occur, albeit at values that more appropriately reflect the underlying credit and counterparty risks. But what the path to this new risk pricing will look like is still uncertain.
Another uncertainty surrounds the impact of the change in credit conditions on real economic activity. Some firms likely are facing higher costs and less favorable terms. At least to date, however, we do not seem to be seeing an impact on capital spending. Similarly, consumer credit conditions have not changed much in response to the financial turmoil. But the demand for housing has been further reduced because the inability to securitize non-conforming mortgages has contributed to a large cutback in such originations, particularly for sub-prime loans.
To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. Under one scenario, the effects on overall growth will be fairly isolated to declines in residential construction — similar to our experience in 2006 and early 2007. However, there is a less benign possibility. Housing demand and prices could weaken a good deal more than we expect — either because a new shock hits the sector or because we have underestimated the weakness already in train. A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth.
I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against. The challenge is to calibrate the insurance in light of the lower probability of the spillover event occurring. Furthermore, if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook.
Indeed, not all of the risks to the economic outlook are on the downside. The effects of financial difficulties on real activity are hard to predict. For example, recall 1998, when concerns about the fallout of the Russian default on other emerging market debt and the difficulties related to LTCM led to a freezing of activity in certain financial markets. Despite all of the concerns about how this might affect economic activity, in 1999 real GDP ended up growing 4.7 percent and significant resource pressures emerged.
Returning to the current situation, the process of assessing credit exposure appears to be well underway and a number of large financial institutions already have reported losses on their books. There is also some evidence suggesting that investors are more willing to differentiate between commercial paper issuers based on the quality of the underlying assets. Markets also have become somewhat more receptive to high-yield issues and to term lending. In addition, term premia in markets where liquidity was impaired have come down, though they remain above levels that prevailed in late July. There still is a way to go. Improvements are not uniform, and risks remain. However, markets are functioning better than they were two months ago.
The Outlook and the Policy Picture Going Forward
Putting all of this information together, our baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy.
Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast. True, housing markets have tumbled further — sales fell sharply in August, new construction dropped a good deal further in August and September, and prices have softened. But the rest of the economy appears to be moving forward. Sales at automotive dealers and other retailers posted good numbers (in real terms) in August and September, indicators point to further increases in business investment, and industrial production has continued to rise. Importantly, according to the revised data, nonfarm payrolls increased an average of about a 100,000 per month rate in August and September — a pace we think is in line with demographic trends and an economy growing at potential.
With regard to inflation, we do not see any large movement one way or the other from current levels of core price inflation. Here the risks seem two-sided. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to mitigate the potential for this.
The latest numbers on inflation have been positive. The 12-month change in core PCE prices remained at 1-3/4 percent in August. We do not have the PCE index for September yet, but the CPI data for September that were released last week showed a moderate increase in core prices. At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09. Relative to our outlook six months ago, this is a favorable development.
Conclusion
Looking ahead, we will need to monitor developments regarding the outlook for both growth and inflation quite carefully. We will have our eyes open for the downside risks that I mentioned earlier. Events also could transpire that cause us to boost our growth projection. In addition, we cannot afford to be lax on the inflation front. Although I am optimistic about the chances for further inflation improvements, I would see any increase in inflation or inflation expectations from their current levels as a serious concern.
Over time, the current set of uncertainties and risks will fade. However, others will take their place — some will appear to be new and unique, and some we will have faced before. In any event, my views on monetary policy will depend on my outlook for the economy, the risks and uncertainties embedded in the forecast, and how these relate to the achievement of the Federal Reserve's dual mandate for maximum sustainable growth and price stability.
*The views presented here are my own and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.
