Tuesday, October 23, 2007

New Chicago Fed President Charles Evans on the Economic Outlook

Charles Evans, the new President of the Chicago Fed and current FOMC voter, gave his first speech yesterday on the Current Economic Outlook. After reading through it a couple times, I get the impression that his thinking on monetary policy is very much aligned with Bernanke, Kohn and Mishkin.

The speech covers a lot of ground in a very clear way, so I'd encourage you to read the entire thing. I want to focus here just on his discussion about "acknowledging uncertainties" when deciding on monetary policy. Just about every recent Fed speaker has mentioned significant downside risks to the economic outlook. Evans tells us how these tail risks to the outlook effect policymaking:

Some risks relate to possible events or extreme macroeconomic outcomes that are not very likely to occur, but whose cost in terms of output or inflation could be quite large. In such cases, it is prudent to adjust policy to be more or less accommodative than we otherwise would as insurance against the highly adverse outcome. These are the risk management or pre-emptive views of policy I mentioned earlier, and they are a common component in central bankers' strategies. But if the extreme event does not occur or its influence subsides quickly, then it is incumbent upon policymakers to recalibrate policy — and to do so from a baseline that accounts for how the additional insurance put into the system affects the outlook for growth and inflation.
He then describes the particular downside scenario that he's thinking about:
To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. ... Housing demand and prices could weaken a good deal more than we expect. ... A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth.

I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against. The challenge is to calibrate the insurance in light of the lower probability of the spillover event occurring. Furthermore, if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook.
I read that as saying they will continue to cut rates until Fed funds is below neutral. The only real question is: "Where's neutral?" Evans estimates potential real GDP growth at "somewhat above 2.5%." Adding that to current core PCE inflation of 1.75% YoY, that implies neutral is about 4.25%. If they're only thinking of 25bps of insurance, that gets us to a target fed funds rate of 4%, or three more 25 bps cuts. It's important to note that getting to a 4% rate does not require any of the growth risks to materialize, just for them to be out there. If housing starts to spill-over as the Beige Book has hinted, we should expect to see much lower rates.

No comments: