DETROIT (MNI) – The following is the third of four sections of the
remarks of Chicago Federal Reserve Bank President Charles Evans Monday,
prepared for the Michigan Council on Economic Education on the topic of
“Mandate Responsibilities: Maintaining Credibility during a Time of
Immense Economic Challenges:”

Other critics raise the specter of 1970s-like structural changes in
the economy. Such changes, they argue, have reduced our productive
potential, in particular the mechanisms by which resources most
notably labor move from declining to expanding sectors of the
economy.3 I am acutely aware of the costs of making such an error. No
central banker wants to repeat the painful experiences of the 1979-83
period. Indeed, the FOMC discussed this issue at great length (see the
minutes of our January 2011 meeting).4 However, I have yet to see
empirical evidence based on a modeling framework that successfully
captures U.S. business cycle dynamics that shows such supply-side
structural factors can come close to explaining the huge shortfalls in
actual GDP from trend and the high level of unemployment. For example,
extended unemployment insurance and increased difficulties in matching
workers to vacant jobs may have resulted in a transitory increase in the
natural rate of unemployment, but the analysis I’ve seen doesn’t get you
close to the 9 percent rate we currently are experiencing.

The Policy Loss Function

The macroeconomics literature often describes the policymaker’s
problem as one of minimizing societal costs of bad outcomes– which it
mathematically approximates by the sum of the squared deviations in
inflation from its target and the unemployment rate from its so-called
natural rate. It turns out that a conservative and tough-minded central
banker should value these deviations about equally.5 Accordingly, an
inflation rate of 5 percent against an inflation goal of 2 percent is
the same sized loss as an unemployment rate of 9 percent against a
conservative estimate of 6 percent for the natural rate of unemployment.
Today, we are facing an unemployment rate of 9 percent with little
prospect of meaningful declines soon and the medium-term outlook for
inflation is under 2 percent.

This policy framework is often described as flexible inflation
targeting. In strict inflation targeting, all policy actions are aimed
at hitting an inflation target. In flexible targeting, policymakers
balance deviations from both the unemployment and inflation targets.
Usually, the policy prescriptions from the two targets are not in
conflict. Above- target unemployment is typically associated with muted
inflationary pressures, and accommodative policies are appropriate to
reduce both gaps from their respective targets. At times, however,
conflicts can occur. When they do, a flexible targeter does not accept a
large miss in one target in order to hit the other perfectly, but
instead accepts moderate misses in both in order to minimize the total
loss. A corollary is that any flexible inflation targeter has to accept
the idea that optimal policy may involve inflation running for a time
above the long-run target if that is a consequence of policies designed
to bring unemployment more in line with its target rate.

(3 For example, the economy may have experienced some permanent
loss of potential output during the recession partly because of reduced
capital deepening with lower rates of investment and partly because of
other factors. In addition, extended unemployment insurance benefits and
difficulties in matching workers with jobs may be temporarily pushing up
the natural rate of unemployment.)

(4 See Board of Governors of the Federal Reserve System (2011).)

(5 See Evans (2011).)

Policy Prescription

Given the economic scenario and inflation outlook I have discussed,
if it were possible, I would favor cutting the federal funds rate by
several percentage points. But since the federal funds rate is already
near zero now, that’s not an option. To date, the Fed’s policymaking
committee, the FOMC, has used a number of nontraditional policy tools to
impart greater financial accommodation. I have fully supported these
policies. However, I would argue for further policy actions based on our
dual mandate responsibilities and the strong impediments of the
financial crisis.

In a recent Financial Times commentary, Michael Woodford of
Columbia University discussed how greater clarity in policy
communications would help 6. I agree. As I see it, current financial
conditions are more restrictive than I favor, in part because
households, businesses and markets place too much weight on the
possibility that Fed policy will turn restrictive in the near to medium
term. The FOMC’s announcement in August that it anticipates short-term
rates remaining low through mid-2013 was certainly a step in the right
direction because it significantly raised the hurdle for early policy
tightening. But I think we could go even further. One way would be to
make a simple statement about our policy plans that clearly lays out our
conditionality in terms of our dual mandate responsibilities and
observable economic data. This could be done by stating that we would
hold the federal funds rate at extraordinarily low levels until
particular markers were reached with regard to the unemployment rate and
inflation. I will talk about this in more detail in a minute.
Alternatively, I have previously discussed how state-contingent,
price-level targeting would work in this regard.7 Another possibility
might be to target the level of nominal GDP, with the goal of bringing
it back to the growth trend that existed before the recession. I think
these kinds of policies are worth seriously contemplating as ways to
enhance economic growth and employment while maintaining a disciplined
inflation performance.

Policy Problem

Such conditional-trigger and level-targeting policies could result
in inflation running at rates that would make us uncomfortable during
normal times. I understand this discomfort. The difficulties in
reestablishing credibility following the inflation of the 1970s weigh on
all central bankers’ minds. And many of us are conditioned by the work
of Ken Rogoff 8 and others, who note that in normal times, we may want
conservative central bankers as institutional offsets to what would
otherwise be inflationary biases in the monetary policy process.

Given this strong anti-inflationary orientation of central bankers,
appropriate policy actions may face a credibility challenge of a
different nature than we are used to talking about can conservative
central bankers be counted on to commit to keeping interest rates low in
the event inflation rises above their long-run target? To the degree
that the public doubts that we will, current accommodation is reduced
because expected future short-term rates, interest rate uncertainty and
associated risk premiums all will be higher than they otherwise would
be. Premature talk of exit strategies or assertions of inflation targets
as ceilings only feed the perception that we are not committed to the
low rates. And thus, I think we are seeing such added restraint today.

(6 Woodford (2011).
7 Again, see Evans (2011).
8 Rogoff (1985).)

-more- (3 of 4)

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