The President of Federal Reserve Bank of Chicago came to speak at the CFA Society of Iowa Strategy Dinner last night and I was lucky enough to attend. Although, we did not learn anything really new from the speech, Evans nicely summarized the Fed’s motivation for implementing the unemployment and inflation thresholds that are his namesake along with the reiterating that the Fed will not remove accommodation, whether it be QE or the near zero federal funds rate too quickly. His view on the economic growth was pretty optimistic. Evans stated,
I am optimistic that we have appropriate policies in place to help the economy achieve escape velocity by 2014. So, after rising a disappointing 1-1/2 percent in 2012, real gross domestic product (GDP) should increase in the range of 2-1/2 to 3 percent this year and then grow between 3-1/2 and 4 percent in 2014, according to my forecast. This growth ought to be sufficient to bring the unemployment rate close or maybe even a little below 7 percent by the end of next year.”
Still, he expected the interest rate to be near zero at least through mid-2015 (that’s when he forecasts we will hit the key 6.5% unemployment rate. He stated that if the unemployment rate fell faster than expected and inflation was not too much below 2%, then, they could increase rates ahead of mid-2015. That is the point of having the near zero interest rate policy tied the economy not to a calendar date.
He also provided clear motivation for why the Fed wants to the economy to be not only recovering but sustainably recovering for some time before they raise rates. They are keeping rates low beyond when the economy recovers to make up for the lost time when the Fed hoped to have fed funds rate below zero.
The thresholds for increasing the fed funds rate were chosen so that rates will remain near zero even after the recovery becomes more firmly entrenched. This delay is a feature of what modern macroeconomic theory tells us is the optimal policy response to the extraordinary circumstances we have faced over the past four years. Given the weak state of the economy, we would have liked to take policy rates negative. Of course we can’t do that; so, instead, the federal funds rate has been stuck at zero since December 2008. Because of this constraint, theory says that a central bank should promise that even when economic activity recovers, it will hold rates below what they typically would be for some additional time. This makes up for the period of time when we could not drive rates negative. In other words, by postponing the time of policy liftoff, the average path for rates is closer to being right over time.
Evans also clearly stated his requirements for removing quantitative easing. He wants to see not only job growth of around 200,000 per month for about 6 months but he wants GDP growth to move about potential. That statement makes it pretty clear that Evans was not part of the “many” members concerned about the risks to continued asset purchase purchases at January Fed meeting. Evans fears that removing accommodation too quickly will lead us down Japan’s path—5 recessions in 15 years.
I do agree with him inflation is less of threat (the January core PCE) than turning Japanese. I also think that better communication from the Fed (that 6.5%/2.5% rule) is big step in removing interest rate policy uncertainty for Wall Street and Main Street. At some point prolonged zero interest rates may have unintended consequences. The new member of the Fed Board of Governors, Jeremy Stein, talked about one of the unintended consequences of prolonged periods of low rates –a good ol’ credit bubble—in speech early last month. While we are by no means not close to a bubble yet, in my mind, Jeremy Stein’s appointment to the Fed to basically spot bubbles and ensure financial market stability is reassuring…