Regional President Speech

A Perspective on Unconventional Monetary Policy Macro Workshop 2014 Central Bank of Turkey Istanbul, Turkey June 2, 2014 Charles L. Evans President and CEO Federal Reserve Bank of Chicago The views I express here are my own and do not necessarily reflect the views of the Federal Reserve Bank of Chicago, my colleagues on the Federal Open Market Committee (FOMC) or within the Federal Reserve System. 00 Three Big Events in Fed History  The Great Depression (1929-1938) – “Inept monetary policy” failed to adequately combat credit contraction, deflation, and depression  The Great Inflation (1965-1980) – Monetary policy failed to recognize structural changes and expectational dynamics that led to double-digit inflation  The Treasury Accord (1951) – An example highlighting the importance of central bank independence 11 Academic Foundations of Modern Central Banking  Great Depression: Central banks must address nominal crises – Friedman and Schwartz (1963) – Bernanke (1983, 1985)  Great Inflation: Central banks must distinguish real from nominal cycles – Friedman (1968) – Lucas (1972) – Kydland and Prescott (1982)  Central bank independence: Central banks must be able to act as necessary – Kydland and Prescott (1977) – Barro and Gordon (1983) – Rogoff (1985) 22 Long-Run Strategy for Monetary Policy (January 2012, reaffirmed thereafter every January)  𝝅 ∗ = 2% PCE inflation 𝒏  𝒖 ~ 5.2% – 5.6% time-varying 𝒕 – Central tendency of long-run sustainable level from the Summary of Economic Projections (SEP)  Balanced approach to reducing deviations of inflation and employment from long-run objectives 33 Persistently Low Inflation and Wage Growth Total PCE Price Index (level) Dec. 2007 120 2% Price-Line from December 2007 Average PCE Inflation Path Implied by FOMC (2000-2007): 2.3% Inflation Forecasts 100 80 2000 '02 '04 '06 '08 '10 '12 '14 '16 Wage and Compensation Growth (percent change, year-over-year) 6 Average Hourly Earnings 3.5% = 1.5% productivity growth + Employment Cost Index 2% inflation 3 0 2000 '02 '04 '06 '08 '10 '12 '14 '16 Source: Inflation forecasts are from the March 19, 2014 FOMC Summary of Economic Projections 44 Inflation is Low Globally Consumer Inflation (year-over-year percent change, deviation from target) 2 1 Latest 2008-2013 avg. 2000-2007 avg. 0 -1 -2 -3 U.K. U.S. Eurozone Switzerland Sweden Denmark Norway Japan Consumer inflation in the U.S. is as measured by the total price index for Personal Consumption Expenditures; in other countries, it is measured by the Consumer Price Index. Latest data are year-over-year changes in the most recently 55 published monthly price index. Bull’s-Eye Accountability for Fed’s Dual Mandate Loss Function 𝑳 = 𝝅 − 𝝅∗ 𝟐 + 𝟎.𝟐𝟓 𝒚 − 𝒚∗ 𝟐 (percent) 𝑳 = 𝝅 − 𝟐 𝟐 + 𝒖 − 𝒖𝒏 𝟐 𝝅 = 5.6% Inflation 𝒖 = 9% 𝝅∗ 2015 2016 2014 September 2011 2012 Current 2013 Unemployment 𝒖𝒏 66 2014 – 2016 values are midpoints of FOMC participants’ Summary of Economic Projections as of March 19, 2014. Bull’s-Eye Accountability for Fed’s Dual Mandate Loss Function 𝑳 = 𝝅 − 𝟐 𝟐 + 𝒖 − 𝒖𝒏 𝟐 (percent) 𝝅 = 3.8% Inflation 𝒖 = 7.2% 2015 𝝅∗ 2012 2016 2014 2013 Current 𝒖𝒏 Unemployment 77 2014 – 2016 values are midpoints of FOMC participants’ Summary of Economic Projections as of March 19, 2014. Bull’s-Eye Accountability for Fed’s Dual Mandate Loss Function 𝑳 = 𝝅 − 𝟐 𝟐 + 𝒖 − 𝒖𝒏 𝟐 (percent) 𝑳 = 𝟐 𝝅 − 𝟐 𝟐 + 𝒖 − 𝒖𝒏 𝟐 Inflation 𝝅 = 3.0% 2015 𝒖 = 7.3% 𝝅∗ 2012 2016 2014 2013 Current 𝒖𝒏 Unemployment 88 2014 – 2016 values are midpoints of FOMC participants’ Summary of Economic Projections as of March 19, 2014. Why Has Achieving Dual Mandate Been So Hard?  Deleveraging in the aftermath of the financial crisis  Global risks  Unusually restrictive fiscal policy  Monetary policy constrained by zero lower bound 99 Policy Rate Constrained by Zero Lower Bound Fed Funds Rate (percent) 8 6 4 History 2 Q1-2014 0 Taylor Rule (1999) based on CBO output gap -2 -4 -6 1999 '01 '03 '05 '07 '09 '11 '13 In the period prior to the explicit inflation target set by the FOMC, the Taylor Rule is constructed using long-run inflation 111000 forecasts from the Survey of Professional Forecasters, or when available, from the Summary of Economic Projections. After 2012, the Taylor Rule is constructed using the FOMC’s 2 percent long-run inflation target. Policy Tools at the Zero Lower Bound  Constrained optimal policy approach (Taylor 1979)  Three ways to approximate optimal policy at the ZLB – State-contingent price level targeting – LSAPs – Forward guidance and inertial policy rule 1111 Alternative Policy Prescriptions – Yellen (2012) Federal Funds Rate (percent) 6 Taylor Rules: 5 𝑹 = 𝟐.𝟎+ 𝝅 +𝟎.𝟓 𝝅 −𝟐 +𝜶𝒈𝒂𝒑 𝒕 𝒕 𝒕 𝒕 Taylor 1999: 𝜶 = 𝟏.𝟎 Taylor 1993: 𝜶 = 𝟎.𝟓 4 Optimal Control: Min 𝝅 −𝟐 𝟐 + 𝒖 −𝒖𝒏 𝟐 +𝚫𝑹𝟐 𝒕 𝒕 𝒕 3 2 Optimal Control Taylor 1993 1 Taylor 1999 0 2011 '12 '13 '14 '15 '16 '17 '18 Source: Janet L. Yellen, “Perspectives on Monetary Policy.” Boston. June 6, 2012 111222 Progress toward the Dual Mandate Goals with Alternative Policies– Yellen (2012) Unemployment Rate PCE Inflation (percent) (4-quarter percent change) 10.0 3.5 9.0 3.0 Optimal Control Taylor 1999 Peak: 2.3% Taylor 1993 8.0 2.5 7.0 2.0 6.0 1.5 Optimal Control Taylor 1999 Taylor 1993 5.0 1.0 4.0 0.5 2011 2012 2013 2014 2015 2016 2017 2018 2011 2012 2013 2014 2015 2016 2017 2018 Source: Janet L. Yellen, “Perspectives on Monetary Policy.” Boston. June 6, 2012 111333 State Contingent Price Level Targeting – Evans (2010) Core PCE Price Index (Index, 2005 = 100) Dec. 2007 130 10 120 8 2% Price Level Target 110 6 FOMC Inflation Forecasts 100 4 90 2 80 0 20072007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 Source: Core PCE data are from the Bureau of Economic Analysis. Inflation forecasts are from the June 2010 FOMC 111444 Summary of Economic Projections. State Contingent Price Level Targeting – Evans (2010) (cont.) Core PCE Price Index and Inflation (Index, 2005 = 100, Q4/Q4 inflation) Dec. 2007 130 10 Price Level 120 8 2% Price Level Target 110 6 FOMC Inflation Forecasts Y/Y Inflation 100 44 Example Inflation Path Consistent with Price Level Target 90 22 2% Inflation Target 80 00 20072007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 Source: Core PCE data are from the Bureau of Economic Analysis. Inflation forecasts are from the June 2010 FOMC 111555 Summary of Economic Projections. LSAP Effects on Long-Term Interest Rates  Wide range of estimates regarding the effect of LSAP on Treasury rates through – Portfolio balance effect on term premia Reasonable estimate is $500 billion of LSAP worth  about 25 bps on 10-year Treasury rates – Signaling effect on expected future short-term rates 1166 Forward Guidance – Numerical Thresholds (December 2012) Unemployment Rate PCE Inflation (percent) (4-quarter percent change) 10.0 3.5 9.0 3.0 Optimal Control Taylor 1999 FOMC Threshold Peak: 2.3% Taylor 1993 8.0 2.5 7.0 2.0 FOMC Threshold 2017Q1 2015Q1 6.0 1.5 Optimal Control 2016Q1 Taylor 1999 Taylor 1993 5.0 1.0 4.0 0.5 2011 2012 2013 2014 2015 2016 2017 2018 2011 2012 2013 2014 2015 2016 2017 2018 Source: Janet L. Yellen, “Perspectives on Monetary Policy.” Boston. June 6, 2012 1177 2013 Taper Tantrum - Forward Guidance, LSAPs, and Signaling Fed Funds Rate (percent) 4 Central Tendency of FOMC Long-Run Projections 3 Key Events: Sep. 10 May 22: Chairman Bernanke’s testimony before the Joint Economic Committee, U.S. Congress June 18-19: FOMC meeting & press conference September 17-18: FOMC meeting & press conference Sep. 19 2 June 18 1 May 21 History 0 2012 '13 '14 '15 '16 '17 111888 Balance Sheet Normalization Projected SOMA Holdings 2016 Q4 (FOMC SEP): (Billions of dollars) 𝝅 = 𝟏.𝟖𝟓% 𝒖 = 𝟓.𝟒% 5,000 4,000 Updated Baseline (2013) 3,000 Buy-and-Hold Realized (2012) 2,000 Counterfactual (2013) 1,000 0 2008 2010 2012 2014 2016 2018 2020 2022 2024 Source: Federal Reserve Bank of New York. LibertyStreetEconomics.NewYorkFed.org. Baseline SOMA projections based on primary dealer expectations. Counterfactual scenario assumes the use of only 1199 conventional monetary policy tools (Treasury bond purchases at roughly the rate of growth of currency in circulation). Buy-and-Hold scenario assumes no asset sales. Date of projection given in parentheses (end of year). FG and FOMC “Appropriate” Policy Rates 6 Taylor '93: 𝟐+𝛑 +𝟎.𝟓 𝝅 −𝟐 +(𝒖𝒏−𝒖 ) 5 𝒕 𝒕 𝒕 𝒕 Inertial Taylor '99: 𝟎.𝟖𝑰 +𝟎.𝟐[𝟐+𝝅 +𝟎.𝟓 𝝅 −𝟐 +𝟐 𝒖𝒏−𝒖 ] 𝒕−𝟏 𝒕 𝒕 𝒕 𝒕 4 Market Expectations 3 2 1 0 2014 2015 2016 Long-Run Source: Interest rate forecasts are from the March 19, 2014 FOMC Summary of Economic Projections. Market expectations are from OIS futures as of May 29, 2014 2200 Additional Topics  Monetary Policy and Financial Stability Risks  Exit Principles 2211 MP and Financial Stability: Mandates and Tools  Tensions from low interest rates – Highly accommodative MP appropriate at ZLB to obtain (𝒖 𝒏, 𝝅 ∗). – But such policy can encourage additional risk taking  Degrading MP tools to mitigate financial instability risks would lead to inflation below target and additional resource slack  In order to avoid excess risk-taking, use combination of supervisory oversight, macro- prudential tools (separate from MP tools), and market discipline 2222 Looking Ahead: Policy Normalization  At some point, achievement of bulls-eye (𝒖 𝒏, 𝝅 ∗) will dictate higher interest rates  Need to make sure we can raise short-term market interest rates in the presence of a large balance sheet  New tools to tighten linkages to market rates – IOER, ON RRP, TDF  These are operational issues the in first stages of monetary policy transmission mechanism – No change in transmission from short rates to long rates, asset prices, etc. 2233

Charles L. Evans (2014, June 1). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20140602_charles_l_evans

@misc{wtfs_regional_speeche_20140602_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2014},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20140602_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}