speeches · March 25, 2008
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
Monetary Policy in Times of Financial Stress
New York Association for Business Economics
Harvard Club
New York, New York
Introduction
Thank you for inviting me to share my thoughts about the economy and the nancial circumstances we are currently facing
About a month ago I was in New York to discuss monetary policy in light of nancial market conditions As part of a very
lively discussion, the group addressed the question of whether the Federal Reserve had appropriate tools to address nancial
market disruptions Since that time, we have seen ongoing turmoil in nancial markets as well as indicators of weakening real
activity, and the Fed has responded by lowering the fed funds rate and by taking a number of innovative steps to target
liquidity conditions in nancial markets
In the course of my remarks today, I will address how I have approached policymaking in this challenging environment I will
then go on to discuss current economic conditions and our expectations for future developments in light of the policies that we
have implemented since August As always, these are my own views and not those of the FOMC or my other colleagues in the
Federal Reserve System
During both normal times and periods of nancial stress, monetary policy decisions depend on the prospects for our mandated
policy goals of stable prices and maximum employment Fortunately, periods of nancial stress are relatively rare in economies
with strong commitments to price stability and low variability in economic activity During normal times, the conduct of
monetary policy will account for nancial conditions as part of our standard evaluation of macroeconomic prospects, and the
usual approaches to policy generally serve us quite well However, during the rare periods of emerging or even actual nancial
stress, policy actions that are more directly related to the changing circumstances in nancial markets may need to be taken
Even in such cases, monetary policy must focus on our macroeconomic goals over the medium term But now the weighing of
risks to growth and in ation must also carefully account for the risk that poorly functioning nancial markets will disrupt real
economic activity
When thinking about policy adjustments during normal times, a useful benchmark is the line of research on policy rules
pioneered by John Taylor This research indicates that most historical policy actions have been systematic responses to changes
in the prospects for our goal variables of output growth, employment, and in ation The main ideas are the systematic response
component, and that particular rules are benchmarks for typical policy Financial developments typically play a role in these
systematic responses through the normal e ects of changes in the funds rate on other credit conditions that a ect the real
economy
Of course, even Taylor's research points out that periods of nancial stress may require policy responses that di er from the
usual prescriptions It's not that we downgrade our focus on the policy goals It is that during these times we often are highly
uncertain about how unusual nancial market conditions will in uence in ation and economic activity In some cases, the
baseline outlook may be only modestly a ected by these conditions, but there may be risks of substantial spillovers that could
lead to persistent declines in credit intermediation capacity or large declines in wealth These in turn would reduce business
and household spending In such cases, policy may take out insurance against these adverse risks and move the policy rate
more than the usual prescriptions of the Taylor Rule If the downside spillovers do materialize, then policy may have to be
recalibrated further
Part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum
employment and price stability over the medium term And if further policy adjustments become necessary, they need to take
into account the insurance that is already in place In addition, when risks subside, promptly moving policy to appropriate
levels will reiterate and reinforce our commitment to our fundamental policy goals
Now, let me discuss how I see nancial markets and nancial stability tting into our policy goals There is no analogy in
nancial markets to macroeconomic price stability The prices of nancial products may change quite substantially when new
information arrives Indeed, one of the most important activities of nancial markets is price discovery—the e cient
assimilation of all available information into asset values This promotes the appropriate allocation of capital among competing
demands and supports maximum sustainable growth And it is this e cient functioning of markets that is our concern with
regard to nancial stability
Most of the time, monetary policy and nancial markets intersect directly at our primary policy tool, the federal funds rate To
alter the trajectory of in ation and economic growth toward their goals, changes in the federal funds rate directly alter short-
term risk-free rates of interest Perceptions of our willingness and ability to adjust future policy then may also alter risk
premiums in xed-income markets and result in a change in the cost of nancial credit to numerous other borrowers
When the economy is weak and we lower rates to stimulate activity, projects that previously had too much risk relative to their
expected return become more attractive for two reasons: The future returns may look better, and the nancing costs are lower
And this may be a good thing if, for example, it can help stimulate an economy that is mired in a situation where overcautious
businesses or households are holding back on investment and spending
As an aside, gauging the appropriate level of caution by businesses and households at any given time is di cult Simply
observing decisions and investments as they are made is not enough For example, in an environment where uncertainty is high
and market liquidity is low, only investment projects that reduce the overall risk pro le of the rm or that have a very high
probability of success may seem worthwhile Of course, in the end, the investment strategy may turn out to be more cautious
than had been understood ex ante The greater caution could be due to overly negative assessments of the size of the
investment payo s, or the level of diversi cation achieved by the portfolio as the returns to the various investments turn out to
be less correlated than had been feared and market conditions normalize
Now, let me return to how policy can deal with nancial disruptions At times, adjusting the federal funds rate may not be
enough to address the special circumstances we face in nancial markets, particularly with regard to liquidity and the smooth
functioning of markets When markets are illiquid, uncertainty about asset values is large In these circumstances, lenders are
often unwilling to accept hard-to-value and illiquid assets as collateral, and as a result, market participants nd it increasingly
di cult to convert these illiquid, but otherwise sound, assets into cash or cash-like instruments This in turn complicates the
process of price discovery, increases uncertainty, and poses additional risks to real economic activity Our recent policy
innovations have been designed to address these e ects of illiquidity directly
We have several ways to add liquidity to the economy in addition to normal open market operations: the discount window,
extended to term borrowing, and the new and now expanded Term Auction Facility, as well as foreign exchange swaps to help
enhance liquidity abroad In these operations, we accept collateral others see as less readily marketable I should note that we
apply the standard discount window "haircuts" in our treatment of the collateral
More recently, the establishment of the Term Securities Lending Facility TSLF extended the term of the existing dealer
securities lending program from overnight to 28 days and expanded the set of acceptable collateral On March 16, we created a
lending facility to extend overnight credit directly to primary dealers This facility, known as the Primary Dealer Credit
Facility, or PDCF, will be in place for at least six months and may be renewed as conditions warrant These loans would be
collateralized by a broad range of investment-grade debt securities, again with appropriate "haircuts " Since the primary dealers
include some nondepository institutions, the PDCF required the Fed to invoke its authority under section 13 3 of the Federal
Reserve Act to lend to nonbanks in "unusual and exigent circumstances," when the borrower is not able to "secure adequate
credit accommodations from other banking institutions " The Fed's policy actions in mid-March represented the rst invocation
of this authority since the Great Depression
Together these policy actions expand our role by providing liquidity in exchange for sound but less liquid securities These
policy innovations share important features of increasing both the term and the quantity of our lending and making additional
quantities of highly liquid Treasury securities available to nancial intermediaries This is intended to reduce uncertainty
among nancial institutions and allow them to meet the liquidity needs of their clients
While these policy actions represent major innovations in practice, they are in the spirit of the oldest traditions of central
banking As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely,
against good collateral" whenever there is a shortage of liquidity in markets
Review of the Current Economic Situation
Let me now turn to our assessment of the current economic situation and how the policy actions I've been discussing could
impact the outlook going forward
In assessing the extent of the current slowdown, I nd it useful to look at an index we developed at the Chicago Fed several
years ago to summarize the information in a large number of monthly indicators of economic activity The index is the
Chicago Fed National Activity Index, or CFNAI An index value of zero is consistent with trend growth in overall GDP The
three-month moving average of the CFNAI was -0 87 in February, suggesting little or no economic growth over the last few
months
These challenges are evident in other recent indicators as well The labor market, for example, weakened substantially in
February with overall nonfarm payroll employment dropping 63,000 and private employment falling by 101,000 The
unemployment rate edged down to 4 8 percent, but this was due to a drop in the labor force
Consumption growth is also below its long-run average, growing at an annual rate of 1 9 percent in the fourth quarter of 2007
and softening further early this year Slower income growth, falling consumer sentiment, high food and energy prices, lower
housing and equity wealth, and tighter credit conditions are all restraining consumer activity and are likely to do so for at least
the near term
Growth in business investment likely is moderating as well, re ecting tighter credit conditions and less need to expand capacity
in a slower economic environment However, some impetus to demand should come from advances in high-tech equipment
One plus for recovery is that inventory-sales ratios remain low This suggests that any inventory corrections may be limited
And a bright spot has been net exports The weaker dollar down 30 percent since 2002 and continued growth abroad has
kept exports growing at a healthy rate We have seen notable contributions to growth from the declining trade de cit in 2007,
and prospects are good for additional contributions as we move through 2008
Taking all of this into consideration, our outlook at the Chicago Fed is for weakness in real GDP this year, particularly in the
rst half of the year However, we think conditions will improve in the second half of the year
A number of factors will likely hold back activity for some time The strains on credit intermediation and nancial balance
sheets mean that credit conditions will likely restrict spending The large overhang of unsold homes will continue to restrain
residential investment Greater caution on the part of businesses and consumers will likely limit increases in their discretionary
expenditures as well Because nancial issues are being worked out against the backdrop of a soft economy, we also have to
recognize the risk that interactions between the two might reinforce the weakness in the economy
Nonetheless, other factors point to improvement later in the year We have lowered the federal funds rate by 300 basis points
since September At 2 25 percent, the current federal funds rate is accommodative and should support stronger growth Indeed,
because monetary policy works with a lag, the e ects of last fall's rate cuts are probably just beginning to be felt, and the
cumulative declines should do more to promote growth going forward
The e ects of the scal stimulus bill also are likely to boost spending in the second and third quarters of 2008
In addition, there is productivity Productivity is the fundamental determinant of growth in the longer run—it determines how
we can turn labor and capital inputs into the goods and services we consume and invest The good news here is that, while it is
not as robust as it was in the late 1990s and early this decade, the underlying trend in productivity in the U S economy is still
solid This trend provides a sound base for production and income generation to move forward over the longer haul
The economy's inherent resiliency and internal adjustment mechanisms will also work to support growth One part of the
internal adjustment process centers on housing As house prices fall, more buyers will nd it worthwhile to enter the market
Eventually, price adjustments will stabilize supply and demand, and the drag from residential construction on the economy will
subside In the current situation, another important part of the internal adjustment process is the work the nancial sector is
doing in "price discovery," that is, the process of determining the proper valuation of assets in light of changes in their expected
cash ows and risks to these ows In addition, intermediaries will do more work in restoring their balance sheets Together,
these activities will eventually reduce strains on the real economy from nancial conditions While there are ongoing
challenges, this process has and will be facilitated by our recent initiatives to bolster liquidity and promote orderly market
functioning
Although most of the recent concern about the U S economy has been focused on growth, we must also be mindful of
in ationary pressures The news here has been somewhat disappointing We have experienced large increases in food and
energy prices, and other commodity prices are high In addition, we are hearing numerous anecdotes of rms passing on cost
increases to their downstream customers, and some indicators of in ation expectations have risen The recent numbers on core
in ation—that is, in ation excluding food and energy—have also moved up some over the past several months Core PCE
in ation is now at 2 2 percent—a higher rate than I would like to see in the long run
I want to emphasize here that, while we often talk about in ation in terms of the core measure, we are concerned about
maintaining the purchasing power over all of the goods and services consumed by households Accordingly, our goal of price
stability must be de ned in terms of total in ation Traditionally, we have found it useful to concentrate on the core measure
because it gave us a less noisy reading of longer-run trends in in ation; in turn, this re ected the tendency for food and energy
prices to be volatile in the short run, but to generally average out to the same as core over the medium term However, if
outsized increases in food and energy prices persist, then core becomes a less useful medium-term guide to in ation trends
Furthermore, persistent food and energy price increases will nd their way into in ation expectations, which in turn would
boost core measures So the recent developments in food and energy prices are a concern that deserves careful monitoring
That said, our forecast is for in ation to moderate over the next two years with a leveling out of energy and commodity prices
and an easing of pressures on resource utilization due to the slower pace of economic activity Still, our uncertainty about the
in ation outlook has increased, and we will continue to monitor in ation developments very carefully
To conclude, it is important to remember that the Federal Reserve has a dual mandate—working to foster nancial conditions
that help the economy obtain maximum sustainable employment and price stability As the Committee noted in the policy
statement following the March FOMC meeting, though downside risks to growth remain, the policy actions taken in March, in
combination with earlier moves, should help to promote moderate growth over time and moderate the risks to economic
activity Looking ahead, my policy views will depend on the evolution of these risks, as well as how developments in uence the
price stability component of our dual mandate over the medium term
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2008, March 25). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20080326_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20080326_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2008},
month = {Mar},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20080326_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}