speeches · March 3, 2010
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 03 03 10
CFA Society of Chicago Distinguished Speaker Series: Luncheon
Economic Forecast
Thank you for that warm introduction It’s just over two years since I became president of the Federal Reserve Bank of
Chicago, and I am reminded that one of my rst public speaking engagements was to this group in February of 2008 You'll
recall that my remarks that day were made as the world nancial crisis was in its early stages In fact I spoke to you just before
the collapse of Bear Stearns in mid-March
So much has happened since then, not the least of which is the fact that the crisis and the actions of the Federal Reserve in
helping to resolve it have become a staple for the news media worldwide In fact, it's almost impossible to read a newspaper or
watch television without hearing something about the Fed, the economy, and the nancial crisis
As I have travelled around the country making speeches over the past few months, I nd myself being asked the same three
questions over and over again So for my prepared remarks today, I’d like to address those big questions about the economy
Afterwards, I’ll also give you an opportunity to ask some questions of your own
Let me emphasize that the views that I am presenting today are my own and not necessarily those of the Federal Open Market
Committee FOMC or my other colleagues in the Federal Reserve System
Let’s begin with the question I am asked more frequently than any other: Is the recession really over? In a narrow, technical
sense, the short answer is yes Many broad indicators of economic activity are increasing as we would expect in the early stages
of a recovery Nonetheless, I keep hearing the question because many households and businesses do not yet feel like they are in
much of a recovery Unemployment remains very high, and many businesses are still producing and selling much less than they
did two years ago What people really want to know is when will we make signi cant progress in returning unemployment and
other measures of economic health to more normal levels? We appear to be moving in that direction, but there is much work
to be done
Let me elaborate a little on those points Although 2009 started as a very weak year, it nished well Real gross domestic
product GDP , our broadest measure of economic output, increased at a 4 1 percent rate in the second half of last year A
portion of this improvement re ects the e ects of government stimulus spending But private demand is beginning to rm up
as well For example, in the automobile industry, which was hit especially hard by the recession, sales have held up in recent
months even after the cash-for-clunkers program ended In other industries, many rms that cut production and inventories
very aggressively during the recession are now dialing back their inventory liquidation On balance, the latest data on
manufacturers’ orders have been more positive, both for materials and parts and for capital equipment Demand from abroad is
also increasing; in particular, the emerging-market economies are showing renewed vigor that should bene t U S exporters
In the housing market, the news has been mixed Sales of new homes and housing starts stopped falling early last year and have
been bouncing along without much of a trend over the past several months Sales of existing homes increased a good deal
through most of 2009, but much of the gain was retraced around the turn of the year Subsidies for rst-time home buyers
have contributed to the ups and downs in the data, and we have yet to see how well the housing market will hold up once they
ultimately expire However, the declines in home prices that earlier precipitated the nancial crisis are now attracting buyers,
and so are low mortgage rates Sadly, many of these sales are for foreclosed homes, but at least they are now moving on the
market Last year's sales and the low level of starts have substantially helped to reduce the overhang of unsold homes, which
should help set the stage for a gradual recovery in residential construction
Most forecasters also expect only a gradual recovery in consumer spending In part, this is because the drop in home prices and
the fall in the stock market during the height of the crisis reduced household wealth It’s also because the availability of
household credit has tightened In addition, the unemployment rate currently is at 9 7 percent For states in the Federal
Reserve’s Seventh District, unemployment was 11 percent in December With such a depressed labor market, workers are
seeing little growth in wages and salaries So, with credit tight and households needing to repair their balance sheets, consumer
spending will gain momentum only as people get back to work
Employment is often the last piece of the puzzle to fall into place during a recovery This will certainly be true this time Many
businesses slashed payrolls during the recession, and going forward, many are hoping to keep sta ng levels lean Indeed, even
though output was increasing, employment still fell substantially during the second half of 2009 Toward the end of the year,
however, the pace of job loss moderated signi cantly Some of the businesses that cut their payrolls most deeply during the
recession have begun to rehire workers Others have accommodated recent increases in demand by hiring temporary workers
This is just the rst stage of the recovery process Most employers are very cautious about hiring at this time, given the
uncertainty over the pace of the recovery But I think that many businesses already are nding they can take lean production
only so far These rms should be ready to expand permanent hiring once they see clearer signs of sustained increases in
demand
The picture with regard to nancing conditions is complex to say the least On the plus side, more and more nancial markets
are functioning well without the need for ongoing government support As a result, large rms are able to borrow at reasonable
spreads, both short term in commercial paper markets and long term in corporate bond markets On the down side, the
availability of bank credit remains a signi cant headwind for many small- and medium-sized companies Some of the decline in
bank lending that we saw last year re ects weak demand for loans by businesses wary of taking on new debt burdens in an
uncertain economic environment But at least some of the reduced lending arises from banks’ tighter lending standards These
tighter standards, in turn, appear to re ect banks’ concern over their capital levels and also the credit quality of borrows More
generally, credit ows are being reduced because both borrowers and lenders are still dealing with losses from the recession,
especially the busts in residential and commercial real estate I expect banking conditions to improve, but this is likely to take
some time
Looking ahead, I anticipate that restrictive bank credit, along with business and household caution, will continue to restrain the
recovery’s strength Nevertheless I expect these dampening in uences to abate as we move through 2010 We at the Chicago
Fed expect GDP growth to average 3 to 3-1 2 percent in 2010 Such growth is only slightly above our estimate of the
economy’s potential growth rate, which means unemployment will likely decline only modestly in 2010
Of course, the recovery could exceed these expectations The growth we’re expecting is modest for a recovery following a deep
recession, which is typically followed by a sharp increase in economic activity For example, GDP growth in the year and a half
following the recession of 1981 and 1982 averaged about 8 percent While that’s not the case now, some of the recent data
have been better than expected Increases in con dence could turn into higher spending sooner than we think And an
important longer-term factor is that productivity growth has remained strong Technology continues to advance, and rms
continue to create new products and nd new ways to produce more e ciently Such productivity gains will result in higher
incomes and improving standards of living over the longer term
Well, that was a long answer to a short question about the recovery The second question I’m often asked comes in two
versions The rst version is: Isn’t in ation about to go through the roof? The second version is: Isn’t in ation about to fall
further—aren’t we looking at de ation? The answer is no in both cases: I think in ation will remain relatively stable But the
fact that I get these completely di erent questions highlights the degree of uncertainty currently underlying the in ation
outlook Surveys of consumer in ation expectations, professional forecasters’ projections, and the implied in ation forecasts
from the market for Treasury In ation-Protected Securities all see in ation running close to current rates over the medium
term But these stable in ation expectations balance out some important crosscurrents I’m reminded of the old joke that says if
you put two economists in a room you’ll get at least three opinions Well, that’s especially true now
The current low rates of resource utilization strongly point to lower in ation The 9 7 percent unemployment rate and the still
very low rates of manufacturing capacity utilization are factors that reduce cost pressures and make rms less able to push
through price increases In fact, these factors have signi cantly contributed to a recent decline in in ation The Fed’s preferred
measure of core in ation—the de ator for Personal Consumption Expenditures, or PCE, excluding food and energy—has fallen
from 2 7 percent in August 2008 to 1 4 percent in January 2010 That is a large decline for a relatively slow moving data
series
The people who press me on higher in ation point to the Fed’s expanded balance sheet and the associated large increase in
what economists call the monetary base We all know that too much money chasing too few goods will generate in ation But,
currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those
reserves, they are not generating spending pressure Of course, leaving the current highly accommodative monetary policy in
place for too long would eventually fuel in ationary pressures
With core in ation at 1-1 2 percent, we see the opposing forces of resource gaps and accommodative monetary policy as
roughly balancing out over the medium term Resource slack could result in core PCE in ation coming down a bit more in
2010 and 2011 As resource slack abates in a recovering economy, I expect in ation to move up to about 1-3 4 percent in
2012
To achieve this outlook, monetary policy cannot be passive A large challenge facing policymakers over the next couple of years
will be judging the appropriate timing and pace for reducing accommodation On the one hand, removing too much
accommodation prematurely could choke o the recovery On the other hand, as I noted, if the Fed leaves the current level of
accommodation in place too long, in ationary pressures will eventually build The Fed is preparing for these decisions by
carefully monitoring business activity and remaining alert for signs of incipient in ation In addition, the FOMC is making
sure that it has the technical tools it will need when it decides to reduce monetary accommodation Overall, I am con dent that
monetary policy will bring and keep in ation near my guideline of 2 percent over the medium term
Needless to say, the crisis and recession have kept us busy But we have also devoted a good deal of energy to re ecting on
events of the past several years This is, in large part, because of the importance of the last question I have been asked recently:
What have you at the Federal Reserve learned about how to guard against future nancial crises again creating such a major
recession? It is not always worded so nicely There are, of course, a number of lessons I’d like to touch on a couple of them
now
One lesson is that responding e ectively during times of crisis may require innovative and targeted policy tools As the crisis
arose, we rst used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount
window However, we lowered the funds rate to zero—as far as it can go—and still were facing frozen credit markets and
severely deteriorating macroeconomic conditions We thus turned to nontraditional tools to clear up the choke points These
included providing liquidity directly to nonbank nancial institutions, and supporting a number of short-term credit markets
We also purchased additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of
government-sponsored enterprises These purchases further reduced long-term interest rates
These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction Of
course, in the future it would be best to reduce the chances of facing nancial crises in the rst place by better protecting the
economy from systemic nancial risks Another important lesson is that to be most e ective, nancial market supervision needs
to be based on prospective economic conditions and applied at the same time across the range of institutions This is an
essential aspect of an approach known as horizontal macroprudential regulation Such an approach was taken during the
Supervisory Capital Assessment Program what we called the SCAP In the popular press this was better known as the bank
stress tests This was an important e ort undertaken in the spring of 2009 that went a long way toward stabilizing and
restoring trust in the banking system
During SCAP, the Fed and other regulators worked with the 19 largest bank holding companies to evaluate the banks’ capital
adequacy under two macroeconomic scenarios One was a baseline that embodied the expectations of most professional
forecasters at the time The other was a more adverse scenario, which ended up being closer to how the economy actually
performed As part of the exercise, banks’ assets were grouped into several buckets—categories such as First-Lien Mortgages,
Junior Mortgages, Commercial Real Estate loans, etc Both the banks and the SCAP sta of more than 150 examiners,
economists, accountants, and other bank supervision specialists were asked to evaluate how these assets would perform under
the two scenarios Comparing the di erent assessments and working through them led to a much better understanding of the
strengths and weaknesses of the leading bank holding companies
In the end, the results indicated which institutions would need additional capital to cover their losses and maintain good capital
ratios in the worse-than-expected macroeconomic environment With this information in hand, the Fed, the Federal Deposit
Insurance Corporation FDIC , and the O ce of the Comptroller of the Currency OCC compelled institutions that fell short
of this common benchmark to increase their capital And they did The information made public after the SCAP helped private
investors make more con dent valuations of the banks Nearly all banks then were able to raise new capital on public equity
markets without drawing on additional government funds
I see a number of bene ts to making similar macroprudential stress tests routine Such horizontal cross-bank reviews of
balance sheets and risk exposures can identify potential systemic risks that might escape an institution-by-institution analysis
Furthermore, they provide a ready way for supervisory reviews and actions to respond to the latest information on
macroeconomic developments In addition, going forward, we might consider dynamic capital standards that would require
banks to build their capital base during periods of strong economic growth and high bank pro tability, and let banks draw
down their capital cushions during downturns when pro ts and capital tend to be more scarce
Such proactive bank supervision requires collaboration between economists and regulators The Federal Reserve has many
well-trained and experienced economists gathering intelligence and analyzing incoming data to prepare the Federal Reserve
System’s Governors and Bank presidents for their monetary policy decisions I believe that the same macroeconomic insights
can help promote nancial stability by substantially improving regulators’ ability to identify and assess risks that are relevant to
a range of nancial institutions This was demonstrated during the SCAP and this approach will be applied to other
supervisory e orts
At the same time, we have well-trained and experienced bank examiners who can o er sound judgments on the
creditworthiness of nancial institutions’ balance sheets Such supervisory information can and does make a valuable
contribution to monetary policy analysis For a number of years, we at the Chicago Fed have included information on banks’
nancial condition and lending activity from our sta in Supervision and Regulation in our regular preparation for monetary
policy meetings Since a recovery in bank lending capacity and inclination will be an important indicator of self-sustaining
momentum in the recovery and of the appropriate time to adjust monetary policy, this information is crucial now more than
ever
Just a minute ago, I used the term macroprudential regulation This is part of a shift in our philosophy spurred by the crisis
Since Congress created the Federal Reserve System in 1913, our approach to preventing nancial crises has relied on the
microprudential supervision and regulation of individual banks In theory, ensuring sound lending standards and adequate
capitalization on a bank-by-bank basis would reassure depositors that their money was safe and prevent panics Such panics
were all too common in the late nineteenth and early twentieth centuries, and were important factors leading to the formation
of the Fed If a problem bank slipped through this regulatory safety net, we could use our powers as the lender of last resort to
prevent its weakness from contaminating a broader range of institutions And, if there were macroeconomic consequences,
then monetary policy could be eased to mitigate the overall e ects on the economy
Of course, as Chairman Bernanke and other experts on the Great Depression have noted, the 1930s Fed failed to use these
tools well enough But from then until the current episode, this approach appeared to su ce, even as our nancial system
became more dependent on nonbank nancial intermediaries, such as broker–dealers, hedge funds, and other institutions
beyond the regulatory reach of the Fed and the other banking regulators Nevertheless, the scale and scope of the past few
years’ events have exposed the weaknesses of a bank-by-bank regulatory approach to guarding against the macroeconomic risks
stemming from nancial instability
One highly visible characteristic of our recent nancial instability was the bubble that arose in the housing market and its
subsequent collapse Now, in the aftermath of that bubble’s collapse, there are increasing calls for central banks to be more
proactive in responding to signs that an asset bubble may have emerged This is often described as an imperative to “lean
against potential bubbles,” meaning that the central bank should act to lower asset prices that, according to some benchmark,
seem unusually high Now not all nancial crises arise from bubbles; the implosion of Long-Term Capital Management LTCM
following the Russian bond default is a case in point, so a policy of leaning against bubbles is at best incomplete Moreover,
there are good reasons to think that using one of the traditional monetary policy tools—namely, adjusting the short-term policy
interest rate—to lean against a potential bubble could be ine ective and maybe even counterproductive One argument is that
interest rate policy is too blunt of a tool to e ectively prick bubbles—it cannot be targeted precisely, and thus will a ect other
nancial and macroeconomic variables beyond just the set of asset prices in question A second argument is that the typical
changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices
I continue to nd these two arguments quite persuasive, which is why at this point I think that well-structured regulatory
policy provides the most promise in protecting the economy from nancial crisis
I’d like to conclude at this point, but I hope you’ll recall that the answers to our three questions about recovery, in ation, and
the nancial crisis were yes, no, and we’ve learned a lot Giving shorter answers to these questions is certainly easy and often
necessary, but always frustrating Today, more than at any time in recent memory, people want to know about the Federal
Reserve, the things we do and think about, and how we put the pieces together to create a picture of the current economy
We’re doing our best to satisfy that demand by providing as much information as we can to business people and bankers,
members of Congress, the media, and, most important, consumers and the public
Thank you for the opportunity to be with you today I look forward to your questions
Cite this document
APA
Charles L. Evans (2010, March 3). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20100304_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20100304_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2010},
month = {Mar},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20100304_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}