speeches · October 21, 2007
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
Current Economic Outlook*
Remarks by Charles L Evans
President and Chief Executive O cer
Federal Reserve Bank of Chicago
University of Chicago Graduate School of Business
Chicago, IL
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 A airs The Federal Reserve Bank of Chicago has bene ted 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 rst 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 — rst as a senior sta er 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 nancial periods And most of my
research career has involved studying monetary policy decision-making and its e ects on the economy Indeed, I rst 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 rst speech as President, I will rst 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 di erent 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 e orts 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 Speci cally, I'd like
to talk about three kinds of considerations that I think are always important for coming to a sound policy decision The rst 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 in uence growth and in ation over the coming quarters and years The
second set of considerations concerns the stance of monetary policy Speci cally, 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
in uence the achievement of our dual mandate The nal 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 e ects 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 rst 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 e ect on output and in ation 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 in uence 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 in ation 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 uctuations 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 uctuations across industries, and in ation 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 nancial market innovations that allow for more
e cient allocation of nancing 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 uctuations in output and in ation
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 in ation 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 in ationary implications were not well recognized at the time Looking back, we think now that part of the
slower growth re ected in exibilities that made it di cult for many industries to adjust to higher energy prices The ultimate
outcome was a deep recession in 1973-75 and soaring in ation Eventually, the Volcker Fed had to implement highly
restrictive and costly policies to bring in ation down In contrast, when oil prices began increasing in 2004, core PCE in ation
was just 1-1 2 percent, the underlying trend in productivity was relatively solid, and the energy e ciency 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 exible 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
in ation
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 nancial 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
in ation 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 ows
and aggregate demand and supply Another key determinant is the expected in ation 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
in ation 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
in ation 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 di cult 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 a ecting the amount of liquidity that is ultimately in uencing economic activity and in ation Other
nancial circumstances can work to o set 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 nancial 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 in ation 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 in uence 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 a ects the outlook for growth and in ation
A di erent, 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 signi cantly above or below its sustainable rate and whether in ation will be too high or too
low And it is interesting that we are nally operating in a world with two-sided in ation 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 in ation Indeed, while core in ation 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 in ation 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, nancing conditions for most rms 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 nancial conditions more
accommodative than suggested by the funds rate alone When combined with the risk to in ation from resource pressures, this
suggested to me that a slightly restrictive funds rate was useful to mitigate potential in ationary 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 rst 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 rst half of the decade This factor also tends to signal higher unit labor costs and
in ationary pressures However, on balance, we in Chicago were impressed that the improvements in core in ation 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 in ation in 2008-09 The lower estimate for trend productivity growth and the lower in ation 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 nancial 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 nancing 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 nancing rates
It is important to remember, however, that many nancial 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 nance working capital or longer-run capital expenditures
Nevertheless, nancial 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 nancial markets Those risks had receded And, importantly, they had done so against
the backdrop of a more favorable in ation 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 nancial 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 a ects both how investors value their own books and how they assess the
repayment abilities of counterparties who have been holding such assets to nance future transactions So rms 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 ows 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 re ect 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 rms 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 nancial 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 nancial conditions might evolve and a ect 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 e ects 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 e ects on nancial 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 in ation outlook
Indeed, not all of the risks to the economic outlook are on the downside The e ects of nancial di culties 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 di culties related to LTCM led to a freezing of activity in certain nancial markets Despite all of the concerns
about how this might a ect economic activity, in 1999 real GDP ended up growing 4 7 percent and signi cant resource
pressures emerged
Returning to the current situation, the process of assessing credit exposure appears to be well underway and a number of large
nancial institutions already have reported losses on their books There is also some evidence suggesting that investors are
more willing to di erentiate 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 re ects 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 in ation, we do not see any large movement one way or the other from current levels of core price in ation
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 in ation numbers However, weaker economic activity would tend
to mitigate the potential for this
The latest numbers on in ation 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 in ation 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 in ation 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 a ord to be lax on the in ation front Although I am optimistic about the chances
for further in ation improvements, I would see any increase in in ation or in ation 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
Cite this document
APA
Charles L. Evans (2007, October 21). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20071022_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20071022_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2007},
month = {Oct},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20071022_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}