speeches · August 14, 2008
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 11 24 09
Among Opposing Forces
McLean County Chamber of Commerce
Bloomington, Illinois
Introduction
It's a pleasure to speak to you today Let me start by thanking the McLean County Chamber of Commerce for inviting me, and
Ryan Whitehouse who helped arrange my visit here today
The U S economy currently faces a number of di cult challenges: These include weakness in the housing market, continued
nancial market turmoil, and the potential for more persistent in ation emanating from the surge in food and commodity
prices The con uence of these and other factors have added layers of complexity to the management of monetary policy I
recently returned from our regular policy meeting in Washington, where, after considering all of the issues, the Federal Open
Market Committee decided to leave the federal funds rate unchanged at 2 percent Today, I'd like to share with you some of the
thinking that shapes my views about policy—namely, my thoughts on the near- and medium-term prospects for growth and
in ation, the state of nancial markets, and the role of monetary policy in the current environment Before we begin, though,
let me note that the views I express today are my own and are not necessarily shared by my colleagues on the Federal Open
Market Committee
Current Economic Situation
We are in the midst of a sharp contraction in housing markets that began in 2006 Delinquency rates for residential real estate
loans have more than doubled since the troubles began; single-family housing starts are down about two-thirds; and house
prices have fallen about 16 percent from their peak, as measured by the Case—Shiller home price index The inventory of
homes for sale remains high On average, declines in residential investment have subtracted a bit more than 1 percentage point
per quarter from real GDP growth over the past two years Although it is too early to say we are nearing the bottom of the
housing cycle, in the most recent quarter residential investment reduced real GDP growth by a smaller magnitude—about two-
thirds of a percentage point As any economist will tell you, "less bad" can be a rst step toward improvement
The downward adjustment in housing activity has been associated with a doubling in the fraction of nonperforming mortgages
since 2006 And over the past year, we have seen the deteriorating performance of mortgages and mortgage-backed securities
spill over to other segments of nancial markets Market participants have reassessed the risk pro les of other similarly
structured assets, and prices of these securities have declined as well The re-pricing process has had a signi cant impact on the
liquidity and capital positions of nancial institutions Declines in asset prices and the increase in nonperforming loans have
eroded banks' capital positions In response, many banks have taken steps to raise capital by issuing new equity, reducing
dividend payments, and by selling certain assets But, to the extent that capital ratios have continued to be strained, nancial
institutions have also restricted lending and worked to reduce the riskiness of their portfolios by tightening credit terms and
standards As a result, credit is now more costly and di cult to obtain for many kinds of household and business borrowing
Financial turmoil and weakening housing markets are not the only factors weighing on economic activity Over the past year,
we also have experienced substantial increases in food and energy prices These have reduced the purchasing power of
households and increased rms' costs of materials, which have also weighed on economic growth Labor markets have been
weak Payroll employment has declined steadily over the rst seven months of this year, with a cumulative loss of over 450
thousand jobs The largest job losses have been in the construction and manufacturing sectors Also, the unemployment rate has
risen by over a full percentage point during the past year, reaching 5 7 percent in July Weak labor markets and high consumer
prices have held back growth in real income This, in conjunction with lower housing prices and stock market wealth, has
resulted in a noticeable slowing in growth in consumer spending
There are, however, some positive factors that have helped sustain growth Declines in the dollar and solid growth by many of
our trading partners have led to reductions in our trade de cit, adding substantially to real GDP growth in the second quarter
And, importantly, productivity has increased a healthy 2 8 percent over the past year Productivity measures how much output
the nonfarm business sector can produce for each hour of labor input It is the fundamental determinant of our ability to
generate economic well-being And our workers and businesses have kept productivity on a solid uptrend by continually
developing new productive technologies and new ways to use them
Indeed, in spite of the economic headwinds we face, real GDP was reported to have increased at an annual rate of 1 9 percent
in the second quarter And recent data suggest that this gure will likely be revised up However, this did come on the heels of
stalled growth at the end of 2007 and a gain of only 0 9 percent in the rst quarter of 2008 So, the strong challenges faced by
consumers and businesses have reduced growth But, last January, I was concerned that things could turn out to be much
worse
In addition to the challenges regarding growth, we also are dealing with some unfavorable developments with regard to
in ation At the beginning of the year I expected the in ation picture to be better than it is now The large increases in food
and energy prices that I mentioned earlier have contributed to a 4 1 percent increase in the personal consumption expenditures
de ator over the past year Even core in ation, which excludes both food and energy components, is unsettlingly high, growing
2 3 percent over the year ended in June Indeed, total in ation has exceeded core in ation pretty consistently for over ve
years, with both measures above 2 percent during much of this time I view these persistently high rates of overall and core
in ation as important concerns for monetary policy
Monetary Policy
This brings me to the discussion of how policy is set against the backdrop of such a challenging economic environment I will
begin with a somewhat general perspective The Fed functions under a dual mandate to foster nancial conditions that
promote both maximum employment and price stability Of course, maximum employment must be sustainable This is usually
interpreted as the level of employment that is consistent with a rate of growth that the real economy can maintain over time
without leading to an increase in in ationary pressures We refer to this rate as potential growth Price stability, as former
Chairman Greenspan often said, occurs when in ation does not signi cantly distort the economic behavior of households or
businesses Price stability does not mean that individual prices do not change In ation, in comparison, entails a widespread
increase in prices across a broad spectrum of goods and services I tend to view price stability as core in ation being in the
narrow range of 1-1 2 to 2 percent, and the more volatile overall in ation rate also averaging in this neighborhood over
longer periods of time
In practice there are a number of uncertainties and risks that must be carefully weighed when implementing monetary policy
First, policymakers must carefully assess the rate of potential output growth, in large part by estimating the trends in two of its
key determinants, productivity and working-age population growth In recent years, these two factors suggest potential growth
is in the range of 2-1 2 to 3 percent Second, central bankers rely upon data to evaluate where current growth is relative to
potential But the economy is very complex, and we frequently receive con icting signals So, it can be di cult to appraise the
current situation and project the economy's likely future course Third, given the assessment of the outlook, the Fed determines
if a more accommodative or more restrictive policy is warranted Evaluating the sources of risk to growth and in ation is also
an important part of this decision Finally, we need to deal with the fact that monetary policy takes time to in uence real
economic activity and in ation So, as new information comes in, we are often put in the position of needing to alter course
before the full impact of our past policy actions are completely evident
The current monetary policy environment is even more complicated than usual If we were using battle eld language to
describe our situation, this would be a "three-front con ict " Although real activity is weak, we also are simultaneously
experiencing bad news on the in ation front in the form of higher energy and commodity prices This creates the challenge of
facilitating the economy's return toward more favorable growth rates without igniting greater in ationary pressures The
nancial turmoil and subsequent tightening of credit conditions add another dimension of di culty to the problem I will
return to this momentarily But rst let me discuss the economic outlook and how it is shaping policy decisions
Economic Outlook
Four times a year FOMC participants provide projections for economic growth, the unemployment rate, and the in ation rate
for the current and following two years The most recent projections were submitted at the June FOMC meeting In general,
the Committee's opinion was that growth had been somewhat stronger in the rst half of the year than had been originally
anticipated Even so, the consensus view was that the economy would expand slowly over the next several quarters However,
participants continued to see signi cant downside risks to the forecast for growth The Committee expected higher near-term
headline and core in ation, largely due to the e ects of recent high prices for energy and other commodities
Since these forecasts were made, I think the risks for growth have increased and the risks for in ation remain elevated and a
concern The detail underlying the GDP data and recent numbers for July point to some weakness in growth, particularly after
the e ects of the recent tax rebates recede Consumption fell in June after adjusting for in ation U S car and truck production
and sales declined signi cantly further this spring, and the gures for July continued this trend It is di cult, however, to know
how much of the declines re ect cyclical economic weakness and how much are related to structural factors such as higher fuel
costs and an unfavorable product mix Financial markets remain under considerable stress Labor markets have deteriorated
further, and the housing market outlook continues to be uncertain But inventories are in good shape in most industries And
net exports remain a solid positive, although export growth may taper o some given the softer economic outlook for some of
our major trading partners Despite these risks, as we move forward, I see real GDP growth returning near potential by 2010—
somewhere in the range of 2-1 2 to 3 percent
While energy and commodity prices have moderated somewhat, both headline and core in ation remain high Some measures
of expectations for future in ation remain uncomfortably elevated As energy prices level out and economic growth remains
modest, I think in ation should moderate over the medium term, with PCE headline in ation declining to around 2 percent by
2010 Clearly, this forecast hinges upon developments in energy and commodity prices, as well as containing expectations of
future in ation Both of these present risks to the outlook
Policy Setting
This environment presents substantial challenges to monetary policy As you know, since last September, the Fed has lowered
the fed funds rate from 5-1 4 to 2 percent At the time, most forecasters' baseline outlook was for marked sluggishness in real
economic activity But forecasters also recognized the possibility of falling asset prices severely constricting credit and
potentially intensifying and spreading the slowdown in the housing market into something much more widespread and acute
The Fed determined it prudent to take preemptive action in response to the unfolding situation Our 325-basis-point
cumulative cut in the funds rate was larger than we otherwise might have done in order to insure against the unlikely event of
a severe downturn That said, even though I think the current 2 percent funds rate is accommodative, it is not especially
stimulative This is because the nancial market turmoil has meant that our funds rate reductions have led to less credit
expansion to households and businesses than typically would be the case
Indeed, it has become increasingly clear to me that the fed funds rate alone is neither an adequate nor even an entirely
appropriate tool for addressing instability in the nancial markets Further reductions in the fed funds rate could help provide
additional liquidity to nancial markets as a whole, but not necessarily to the most distressed portions of the market And, in
principle, if pushed too far, excess policy accommodation over an extended period of time would risk igniting in ation
expectations However, the ongoing challenges in nancial markets indicate the continued need for substantial liquidity in
order to facilitate their functioning and to ensure adequate funding for creditworthy businesses and households
Accordingly, the Federal Reserve has created several special lending facilities aimed at providing nancial markets with liquidity
and promoting orderly nancial adjustments Since last August, we have introduced the Term Discount Window, the Term
Auction Facility, the Term Securities Lending Facility, the Term Options Program, and the Primary Dealer Credit Facility
Collectively these innovations are designed to increase market liquidity by lengthening Federal Reserve lending terms, by
reducing the cost of borrowing relative to the fed funds rate, by expanding the range of eligible counterparties, and by
enlarging the pool of eligible collateral I should note that in order to provide the Fed with a cushion against credit risk, the
value of collateral backing the loans at these facilities is set at a discount from the latest market prices for the pledged assets
These facilities have helped stabilize short-term credit markets somewhat and have injected much needed liquidity into the
nancial system The success of these facilities—which, I would like to emphasize, should be measured against the list of
feasible outcomes they can achieve—should help nancial markets work through their problems over time
At our meeting this past week the Fed left the benchmark fed funds rate unchanged at 2 percent Of course, we policymakers
must continuously reevaluate our policies to re ect current and forecasted conditions, and to ensure our assessments of risks
are aligned to meet our long-term policy objectives As I just discussed, from the perspective of last January, the real economy
has performed better than was predicted And while the second half of 2008 will likely be extremely sluggish, the risk of a
severe slowdown seems less likely today than predicted at the beginning of the year In addition, as I also noted, there is clearly
an increased risk to in ation Headline in ation has exceeded core in ation for an extended period of time, and even the latter
has been above 2 percent for some time
In evaluating in ation risks, we must be concerned about energy and food prices being passed through to core in ation We
run the risk of persistent widespread price increases being built into the expectations of households and businesses, and thus
producing persistently higher bases for both in ation measures Some have taken comfort in the fact that in ation has not yet
been built into wage growth as evidence that in ationary expectations have not risen But I am less sanguine because research
indicates that by the time we have statistical con rmation that wages are increasing at rates higher than the rate of growth of
productivity, a persistent rise in in ation most likely would already be in train
There are clearly risks to the in ation outlook if expectations do not remain grounded Any increase in in ation expectations
would pose a risk to achieving our dual goals of price stability and maximum sustainable growth
Conclusion
The current economic landscape poses a three-front con ict for policymakers: sluggish economic conditions with depressed
housing and auto markets, rising in ation risks with high oil and commodity prices, and nancial distress that is restraining
credit growth To date, relatively accommodative monetary policy has taken out insurance against downside risks of disorderly
nancial adjustment turning into a severe economic downturn But rising in ation risks at a time of economic weakness
present some di cult challenges for policy At this point many nancial market liquidity problems are being addressed through
our special lending facilities These additional tools allow our policy actions with regard to the fed funds rate to focus on
broader macroeconomic goals—these are our commitment to price stability and sustainable growth
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, August 14). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20080815_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20080815_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2008},
month = {Aug},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20080815_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}