Regional President Speech

_____________________________________________________________________________________ Long-Run Economic Trends and Monetary Policy Frameworks and Strategies _____________________________________________________________________________________ Charles L. Evans President and Chief Executive Officer Federal Reserve Bank of Chicago Bank of Italy Rome, Italy May 6, 2019 _____________________________________ FEDERAL RESERVE BANK OF CHICAGO The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC. Long-Run Economic Trends and Monetary Policy Frameworks and Strategies Charles L. Evans President and Chief Executive Officer Federal Reserve Bank of Chicago Chicago Fed President Charles L. Evans discussed the implications of long-run economic trends for monetary policy frameworks and strategies. He was speaking to a group of central bankers and academics at the Bank of Italy. His comments reflected his own views and not necessarily those of the Federal Reserve System or the Federal Open Market Committee (FOMC). The slides President Evans used during his presentation are available online, https://www.chicagofed.org/~/media/publications/speeches/2019/05-06-19-long-termeconomic-trends-and-monetary-policy-farmeworks-and-strategies-slides-pdf.pdf. Synopsis of President Evans’s remarks1  There are two important long-term trends that are shaping the U.S. economy, as well as many other advanced economies. o The neutral level of real interest rates and the growth potential of many advanced economies have declined significantly in recent years. In the absence of structural changes, these trends are expected to continue well into the future. o At the same time, inflation in advanced countries has been underrunning the central banks’ targets. 1 Some of President Evans’s remarks at the Bank of Italy were similar to his OMFIF City Lecture given in London last fall and his speech delivered in Stockholm, Sweden, last week (Evans, 2018, 2019). 2  These trends imply that the likelihood of nominal policy interest rates hitting the zero lower bound (ZLB) has increased significantly, potentially limiting the ability of central banks to use conventional monetary policy tools to counteract downturns in the future.  A number of alternative monetary policy frameworks have been proposed to address this potential challenge, including nominal gross domestic product (GDP) targeting, price-level targeting, state-contingent or temporary price-level targeting, and average inflation targets. As part of the wide-ranging review of the Federal Reserve’s monetary policy strategies, tools, and communications, the System will hold a conference in June at the Chicago Fed, at which some of these alternatives likely will be discussed.2  Without prejudging the outcome of this important review, President Evans pointed out some features common to several of the proposed alternative frameworks: o The alternative frameworks can require policymakers to commit to provide extraordinary accommodation not only during ZLB episodes, but also afterward. Policy prescriptions from simple rules are inadequate. o The policies can require a successful commitment to produce temporary—though potentially protracted—periods of above-target inflation following episodes when inflation has persistently run below target. 2 Further information about this event is available online, https://www.federalreserve.gov/conferences/conference-monetary-policy-strategy-tools-communications20190605.htm. 3 o A related set of issues could arise following a protracted period of overshooting a simple level or average inflation target: Policymakers would commit to pursuing tighter-than-usual policies to bring inflation down, potentially generating significant increases in unemployment.  President Evans elaborated on the potential implications for inflation using an illustrative example from one alternative framework. He considered the hypothetical case of adopting a state-contingent price-level target today as proposed by Evans (2010) and Bernanke (2017). o He noted that, given the inflation misses since the financial crisis, the price level today is more than 4.5 percent below a 2 percent trend line starting from the cyclical peak in 2007. o The average inflation rate required to close the gap depends on the time horizon to close the gap—ranging from about 3.5 percent with a two-year horizon to 2.7 percent with a six-year horizon—both noticeably above the 2 percent goal most central banks have.  President Evans also discussed some important questions raised by these features, such as the following: o Can policymakers credibly commit to following through on such policies? o How will the central banks communicate such strategies effectively? o What would the public’s reaction be to extended periods of inflation exceeding the central bank’s inflation goal? What would be the impact on inflation expectations? 4 o What are the financial stability implications associated with the alternative frameworks? Are financial markets and the regulatory environment resilient enough to limit financial stability risks that might arise?  President Evans concluded with his views on general principles that should guide monetary policy strategies, irrespective of the framework. o Policymakers should focus on outcome-based strategies; in the U.S., that means undertaking policies that best achieve the dual mandate goals of the FOMC over the medium term. o Because long-run economic trends have increased the chances of returning to the ZLB, policymakers must be prepared to rely on unconventional tools, including quantitative easing and forward guidance, to provide adequate policy accommodation during some future ZLB-constrained downturns. o Given the necessary focus of monetary policy on the dual mandate goals, financial stability risks are best addressed using macro- and microprudential supervisory and regulatory tools that increase the resiliency of financial markets. o Credibility is key to achieving the dual mandate goals, irrespective of the framework chosen. o In the current policy framework, it is important to enhance the credibility of the symmetric nature of the 2 percent inflation goal. This means a willingness to embrace inflation modestly above 2 percent 50 percent of the time and following through with policy actions and communications aimed at achieving this outcome. President Evans stated he could accept core inflation rates of 5 2-1/2 percent as long as there was no obvious upward momentum and the path back toward 2 percent could be well managed. 6 References Bernanke, Ben S., 2017, “Temporary price-level targeting: An alternative framework for monetary policy,” Ben Bernanke’s Blog, Brookings Institution, October 12, available online, https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-leveltargeting-an-alternative-framework-for-monetary-policy/. Evans, Charles L., 2019, “On risk and credibility in monetary policy,” speech at the National Association for Business Economics (NABE) and Sveriges Riksbank conference, Global Economies at the Crossroads: Growing Together While Growing Apart?, Stockholm, Sweden, May 3, available online, https://www.chicagofed.org/publications/speeches/2019/on-risk-and-credibility-inmonetary-policy. Evans, Charles L., 2018, “Monetary policy 2.0?,” speech for the OMFIF (Official Monetary and Financial Institutions Forum) City Lecture, London, October 3, available online, https://www.chicagofed.org/publications/speeches/2018/10-03-2018-monetarypolicy-2-0-omfif-london. Evans, Charles L., 2010, “Monetary policy in a low-inflation environment: Developing a state-contingent price-level target,” speech at the Federal Reserve Bank of Boston’s 55th Economic Conference, Revisiting Monetary Policy in a Low Inflation Environment, Boston, October 16, available online, https://www.chicagofed.org/publications/speeches/2010/10-16-boston-speech. 7 Long-Term Economic Trends and Monetary Policy Frameworks and Strategies Inflation Bank of Italy May 6, 2019; Rome, Italy Charles L. Evans President and CEO Federal Reserve Bank of Chicago Unemployment The views I express here are my own and do not necessarily reflect the views of the Federal Open Market Committee (FOMC) or within the Federal Reserve System. 1 Low Neutral Interest Rates and Low Potential Growth US Advanced Economies (percent) 4 4 Trend Growth 3 3 Trend Growth 2 2 r* r* 1 1 Q4-2018 0 1985 '90 '95 '00 '05 '10 '15 0 1985 '90 '95 '00 '05 '10 '15 Estimates for Advanced Foreign Economies are GDP-weighted averages across the US, Canada, the Euro Area, and the UK using OECD estimates of GDP at purchasing power parity. Prior to 1995, Euro-Area weights are the summed weights of the eleven original euro area countries. Sources: Laubach and Williams (2003); Holston, Laubach, and Williams (2017); OECD 2 Undershooting Inflation Goals Deviation from Central Bank Inflation Target 1 2008-2018 0 Latest 2000-2007 -1 -2 2000-2007 2008-2018 Latest -3 US UK Source: Various statistical collection agencies Euro Area* Japan 3 Conventional Monetary Policy Easing During Past Recessions Federal Funds Rate (percent) 20 Average easing during recessions1 500 bps Current fed funds rate 240 bps Long-run neutral rate 275 bps 15 1. 1973-2001 10 5 Mar-2019 0 1980 '85 '90 '95 Source: Board of Governors of the Federal Reserve System '00 '05 '10 '15 4 Features of Alternative Frameworks  Commitment to provide extraordinary policy accommodation during and after the ZLB episodes – Policy prescriptions from simple rules (e.g. Taylor 1993, 1999) are inadequate  Following protracted periods of π < π*, commit to π > π*, potentially for extended periods  Following protracted periods of π > π*, possibly pursue polices that might generate significant increases in unemployment 5 Fed Funds Rate And A Traditional Benchmark Federal Funds Target Rate (percent) 9 Taylor Rule: r(t) = rLR(t) + π(t) + 0.5( π(t) – πLR ) + 2( uLR(t) – u(t) ) 6 3 Q1-2019 0 -3 -6 2000 2003 2006 2009 2012 2015 rLR(t) and uLR(t) from Blue Chip Consensus Forecast. Source: February 2019 Monetary Policy Report, Board of Governors of the Federal Reserve System 2018 6 State-Contingent Price Level Targeting Core PCE Price Index 140 120 Current gap: 4.7% Q1-2019 Target By 2021 2023 2025 100 80 2004 '07 '10 '13 Source: Bureau of Economic Analysis and staff calculations '16 '19 '22 Average Inflation Rate Needed 3.6% 3.0% 2.7% '25 7 Some Questions  Can policymakers credibly commit to pursuing the policies prescribed by some of these alternatives?  How will central banks communicate these strategies effectively?  Will the public tolerate protracted periods of π > π*? – Will long-run inflation expectations change?  Following protracted period of π > π*, what is the willingness to increase unemployment to bring inflation down to π*?  What are the financial stability implications of the highly accommodative policies prescribed by the alternatives? 8 My Key Considerations  Focus on outcome-based strategies – In the U.S., focus on the dual mandate  No matter the framework, will need to take actions with unconventional tools (e.g. QE, forward guidance) to counter ZLB  Address potential financial stability risks with regulatory and supervisory tools  Credibility is key and essential for any framework  First step: establish credibility in the current framework – Symmetry of the inflation target 9 

Charles L. Evans (2019, May 5). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20190506_charles_l_evans

@misc{wtfs_regional_speeche_20190506_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2019},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20190506_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}