speeches · May 11, 2008
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 11 24 09
Navigating Market Turmoil
Harper College Economic Forum
Harper College
Palatine, Illinois
Thank you for inviting me to speak today and for that very kind introduction I'm delighted to be here this morning to share
my thoughts on the economy during this challenging period I'd like to say a special thank you to Maria Coons, a former
Chicago Fed employee and member of our extended Fed family I'd also like to extend my personal thanks to Rita and John
Canning Rita serves as a member of Harper's Board of Trustees and John is the Chairman of our Chicago Fed Board of
Directors Maria, Rita, and John all helped to arrange my visit here today
In the course of my remarks today, I will address the subject of monetary policymaking during times of nancial stress I
would like to note that the views discussed today are my own, and not necessarily those of the Federal Open Market
Committee or my other colleagues in the Federal Reserve System
Policymaking
The Federal Reserve has a dual mandate: We are charged with fostering nancial conditions that promote both maximum
employment and price stability We attempt to achieve these goals primarily by setting an appropriate target for the federal
funds rate That's the interest rate at which banks make overnight loans to each other The fed funds rate in uences to varying
degrees the entire array of market interest rates, including those paid by businesses and consumers
Under normal circumstances, nancial markets e ciently channel funds from lenders to borrowers, appropriately supporting
the spending capacity of households and businesses But as we have seen over the past nine months, at times nancial
disruptions can occur Such disruptions can hinder the ow of nancial capital to creditworthy borrowers and reduce their
ability to consume and invest Accordingly, such situations pose special challenges for policymakers
At this point, a review of the recent market turmoil is probably helpful After a period of rapid increases, by the summer of
2007 home prices had leveled o and were starting to decline in some markets Subprime borrowers, who may have been
counting on rising home equity, began to default in signi cant numbers
Complicating these developments were the widespread securitization of mortgages and the repackaging of these securities into
highly complex nancial instruments known as collateralized debt obligations CDOs Securitization and CDOs have turned
out to be a double-edged sword On the one hand, they diversi ed risk among many lenders On the other hand, their
complexity made it di cult to track losses and properly value the portfolios of many nancial institutions This lack of
transparency contributed to the deterioration of nancial market conditions, leading to a re-pricing of risk and a widening of
credit spreads across a broad spectrum of nancial securities For example, not only did the value of mortgage-backed CDOs
fall sharply, but market participants began to question the value of other complex securities, even those with no subprime
exposure Furthermore, many borrowers had to turn to very short-term nancing as lenders were unwilling to commit funds at
normal terms because of uncertainty over collateral valuation and other counterparty risks
In the banking sector, in addition to su ering losses on subprime-related securities, banks were forced to take additional risky
assets back onto their books, which further strained their capital positions This has made them more reluctant to lend
So, in summary, in both the bank and securities markets, many creditworthy borrowers have found credit much more
expensive or sometimes even unavailable at any reasonable price In turn, this has weighed on real economic activity
Setting the Stance of Monetary Policy
I'd like to now turn to how we implement policy In doing so, I will start by discussing how I evaluate three key factors
determining where we set the federal funds rate: These are maximum employment, price stability, and the neutral funds rate I
will then turn to how nancial stress impacts our policy decisions
Maximum Employment
In order for the economy to achieve maximum employment over the long run, it needs to grow at its maximum sustainable
rate, which is also referred to as the rate of growth of potential output This is the maximum rate of real growth the economy
can maintain in the long run without leading to an increase in in ationary pressures Sustainable growth is determined by the
underlying trends in two factors— rst, the availability of labor resources, and second, the productivity of those labor resources
Although these underlying trends are unobservable—and can change over time—at the Chicago Fed, our current analysis of
them suggests that sustainable growth currently is somewhere in the range of 2-1 2 percent per year Most other analysts'
estimates fall in the 2-1 4 to 3 percent range
Price Stability
Our other—and equally important policy goal—is price stability In some sense, price stability is achieved when in ation does
not signi cantly distort the economic behavior of households or businesses Recently, the FOMC further improved
transparency by reporting forecasts more frequently and extending the forecasts' horizon to three years As stated in the FOMC
minutes, participants' forecasts for this third year are "importantly in uenced by their judgments about measured rates of
in ation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain
1
those rates given current economic conditions " In January, policymakers' forecasts for 2010 had growth in the range of most
economists' views for potential and had in ation—measured by both the total Personal Consumption Expenditures, or PCE,
Price Index and the PCE index excluding food and energy—in the range of 1-1 2 to 2 percent This suggests that most
policymakers view price stability as being somewhere in the neighborhood of 1-1 2 to 2 percent
Neutral Funds Rate
Before we go any further, I'd like to describe you how I think about monetary policy in general terms To evaluate the stance of
policy, I start by focusing on the real fed funds rate—that is, the nominal rate less expected in ation—and where it currently
stands relative to a hypothetical longer-run benchmark called the neutral real funds rate The neutral funds rate is the rate
consistent with an economy operating at its potential growth path and with stable in ation There are many factors and
uncertainties involved in assessing the neutral rate With such caveats in mind, I think the neutral long-run real fed funds rate
is somewhere in the neighborhood of 2 to 2-1 2 percent
Real rates above this 2 to 2-1 2 percent neutral point tend to restrict aggregate demand, while real rates below this mark are
accommodative and boost aggregate spending Of course, the real fed funds rate is only one factor a ecting liquidity and credit
conditions As we have seen recently, other credit market developments can work to o set or exaggerate the impulse from
monetary policy
Current Stance of Monetary Policy
Now that I have provided some background for how I approach monetary policy issues, let's talk about the current situation
Market Turmoil
As I discussed earlier, the disruptions in nancial markets that began last August have greatly restricted the ow and increased
the price of credit and liquidity Clearly, this has complicated policymaking Usually, when we decrease the fed funds rate, all
short-term interest rates fall by a similar amount These in turn feed through and a ect interest rates across all maturities As
rates adjust, private markets also update their views on credit risks, and these show through to changes in risk spreads between
private borrowing rates and those on risk-free Treasury debt
Financial stress alters this mechanism: It has boosted the risk premia built into private borrowing rates and substantially
increased the demand for liquid assets that can be easily turned into cash and used to pay liabilities An important example of
these e ects can be seen in the London Interbank O ered Rate, or LIBOR, which is a measure of short-term lending rates
between banks LIBOR is important because it is a common benchmark for many other rates, including those on adjustable
rate mortgages and auto loans The 30-day LIBOR is normally only about 10 basis points above the level of the fed funds rate
2
expected to prevail over the term of the loan However, the recent nancial market stress has pushed its average over 60 basis
points above the expected funds rate; also, this spread has been highly volatile and at one point was over 100 basis points
Because of this increased spread, many borrowers have paid higher rates than would ordinarily have been the case given the
level of the fed funds rate
New Lending Facilities
The current nancial circumstances have added a new dimension to the challenge of monetary policy, and policy has responded
in a number of ways First, we have aggressively reduced the federal funds rate by 325 basis points since September 2007
Second, we have implemented a number of innovative initiatives to increase liquidity in strained nancial markets
The new policies include changes to the Federal Reserve's discount window, through which depository institutions have always
had access to overnight loans Since 2002, the rate of interest we charge borrowers, the primary credit rate, had been set 100
basis points higher than the target federal funds rate However, while we don't view use of the window negatively, historically
banks have been reluctant to use the facility for fear that it would signal weakness or some operational miscalculation To
encourage use of the window, we reduced the wedge between the primary credit rate and the funds rate and allowed
borrowing for terms of up to 90 days We also instituted the new Term Auction Facility, which is an alternative market-based
auction system for depositories to borrow at term from the window
The recent disruptions in nancial markets also have caused serious liquidity problems for another important conduit for
channeling credit, the primary security dealers, which include several major investment banks To address these problems, the
Fed established the Term Securities Lending Facility and the Primary Dealer Credit Facility to lend to them Since the dealers
are nondepository institutions, these loans required the Fed to invoke its authority to lend to nonbanks under section 13 3 of
the Federal Reserve Act Under this act, such lending is only permissible under "unusual and exigent circumstances " Such loans
are the rst extensions of credit by the Federal Reserve to nondepository institutions since the 1930s Our recent actions
regarding Bear Stearns were also authorized by this act
Finally, we have consulted closely with foreign central banks during this period In particular, we instituted swap arrangements
with both the European Central Bank and the Swiss National Bank to help provide dollar-denominated liquidity to European
banks
Together, all of these initiatives have lowered short-term market interest rates, reduced the cost and lengthened the maximum
term of banks' borrowing directly from the Fed, broadened eligible collateral, and expanded lending to nondepository
institutions
Implications for Traditional Monetary Policy
So how does all of this a ect policy? I think it is helpful at this point to note some similarities to the period following the
recession of late 1990 and early 1991 You might recall that after the deregulation of the Savings and Loan industry, many
S&Ls made imprudent real estate loans The ensuing losses substantially reduced the lending capacity of the industry as
insolvent S&Ls went out of business and others were forced to recapitalize In addition, banks were reluctant to lend as they
struggled to bring their capital in line with the then new risk-based standards set by the Basel I Accords These restructurings
created nancial headwinds that made the recovery from recession frustratingly slow In fact this period was later characterized
as a "jobless recovery "
Today, banks again are recapitalizing after making imprudent loans; and again, they are doing so in the face of a sluggish
economy However, one key di erence is that today much more overall lending activity is securitized This has spread losses
among a wider swath of nancial institutions and has made it more di cult to quantify losses As a result, we have seen a
broader disruption of credit ows, even than those of the early 1990s This suggests we may again be in for a period of weak
growth
Now let's consider the stance of policy Today, the nominal funds rate is at 2 percent In January, projections FOMC members
made for PCE in ation in the medium term were in the range of 1-3 4 to 2-1 4 percent This means the real fed funds rate is
close to zero or perhaps slightly negative Looking back at the early 1990s, the nominal funds rate bottomed out at 3 percent
in 1992 Given the higher in ation expectations at the time, this also translated into a real funds rate that probably was close
to zero—just like today
In normal times, a real funds rate near or below zero would be considered highly accommodative However, then, as now, the
boost to aggregate demand from the accommodative funds rate was o set to some degree by nancial market turmoil Because
we think the disruptions today are more signi cant than in the early 1990s, this o set also is larger today In contrast, today
we have in place the various additional measures that provide extra liquidity No such facilities were in place in the early
1990s It is di cult to weigh the various factors But with this di culty in mind, and given my reading today of economic
prospects, my judgment is that the current net stance of monetary policy is accommodative—and this is appropriate in order to
address the way we currently see the sluggish economy unfolding in 2008 I also believe that the current stance roughly
balances out substantial risks to the outlooks for both growth and in ation—which I see as being to the downside for growth
and to the upside for in ation
Economic Outlook
Let's now turn to the outlook for growth and in ation
Current Economic Situation
As you may know, real gross domestic product grew at an annual rate of just 0 6 percent in the rst quarter of the year This
was the same sluggish rate as in the fourth quarter of 2007 Not surprisingly much of this weakness stemmed from the
household sector, as residential investment declined at an annual rate of almost 27 percent and personal consumption grew
well below its long-run average Slower income growth, falling consumer sentiment, higher food and energy prices, lower
housing and equity wealth, and tighter credit conditions are all restraining household spending, and are likely to do so in the
near term And, importantly, the labor market has softened Nonfarm payroll employment fell an average of 80,000 jobs per
month in the rst quarter and dropped an additional 20,000 in April And these losses came on the heels of a steady decline in
job growth over the course of 2007
In the business sector, spending on equipment, software, and structures declined at a 2-1 2 percent rate in the rst quarter,
re ecting tighter credit conditions and less need to expand capacity in a slower economic environment One bright spot has
been net exports The weaker dollar, which is down around 25 percent since 2002, as well as continued growth abroad, has
kept exports rising at a solid rate; last quarter, they grew 5 5 percent
In ation, as measured by the year-over-year change in core PCE prices, was 2 percent in the rst quarter of 2008 But once we
include the volatile food and energy components, total PCE in ation was 3 4 percent
Future Economic Outlook
Looking ahead, our outlook at the Chicago Fed is for continued weakness in real GDP over the near term Activity is likely to
remain weak for a number of reasons Strains on intermediation and nancial balance sheets mean that credit conditions will
likely continue to restrict spending for some time Businesses and consumers could limit their discretionary expenditures
because of caution over the economic environment And housing continues to be a downside factor The unsold inventory of
homes will continue to restrain residential investment, and it will take time for this overhang to unwind
However, eventually the cumulative adjustments in house prices will bring more buyers into the market and activity will
stabilize While we don't expect any signi cant contributions to growth from residential construction for some time, the drag
from the sector ought to at least diminish as we move through the rest of this year and next Similarly, as nancial market
participants revalue portfolios and repair their balance sheets, the drag from credit conditions ought to diminish over time
Furthermore, even given the nancial turmoil, the stance of monetary policy is accommodative and supportive of growth
Productivity growth, although below the lofty rates enjoyed in the late 1990s and earlier this decade, is still solid Finally, the
e ects of the scal stimulus bill are likely to boost spending in 2008
Summing all of these factors, we think conditions will improve in the second half of this year, but not enough to prevent
economic activity from still running at a relatively sluggish pace We expect real GDP growth will return close to potential as
we move through 2009
Regarding the outlook for in ation, we project improvement over the medium term, with core in ation in the range of 1-1 2
to 2 percent by 2010 This forecast assumes that the resource slack being generated by the current weakness in the real
economy will work to o set the cost pressures from higher energy and commodity prices Productivity also is a plus in holding
down costs For example, although compensation increased 3 4 percent over the past year, overall unit labor costs changed very
little because workers were quite productive Productivity, which is the amount of output per hour worked, grew at a quite
healthy 3 2 percent rate
Our forecast also assumes—in line with current readings from futures markets—that energy and commodity prices will
stabilize some time over the medium term Clearly, there are risks to the in ation outlook if this stabilization does not occur
We also could be adversely a ected by higher prices for imported goods Finally, although the persistently high readings of
commodity, food, and energy prices do not appear to have had a major impact on longer-run in ation expectations, we have to
be mindful of their potential to do so Any increase in in ation expectations would pose an important risk to the achievement
of price stability
Conclusion
To conclude, the U S economy has experienced some very large shocks since mid-2007, and economic policy, including
monetary, scal, and nancial, has responded aggressively to address the strains in the economy and nancial markets In my
opinion, monetary policy is accommodative and appropriately situated to address the substantial risks that remain both for
sluggish economic activity as well as unwelcome in ationary pressures
It is important to recognize that monetary policy in uences economic activity and in ation with a lag Furthermore, given the
challenging nancial circumstances, it seems likely that credit conditions will also require adjustment time, as nancial
institutions reevaluate their portfolios and capital needs As a result, the level of uncertainty regarding future developments
continues to be high and the path forward may be uneven We must keep this in mind as we evaluate the outlook I am
con dent that policymakers will continue to respond to future unexpected changes in the environment for growth and in ation
as needed in order to promote sustainable growth and price stability
Notes
1
Summary of Economic Projections in the Minutes of the Federal Open Market Committee, January 29–30, 2008, page 5
2
The expected fed funds rate can be measured by the overnight index swap OIS rate
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, May 11). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20080512_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20080512_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2008},
month = {May},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20080512_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}