Charles L. Evans
President and Chief Executive Officer
The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banks across the country. These 12 banks—along with the Board of Governors in Washington, DC—make up our nation's central bank. As head of the Chicago Fed, Evans oversees the work of roughly 1,400 employees in Chicago and Detroit who conduct economic research, supervise financial institutions and provide payment services to commercial banks and the U.S. government.
Charles L. Evans has served as president and chief executive officer of the Federal Reserve Bank of Chicago since September 2007. In that capacity, he serves on the Federal Open Market Committee (FOMC), the Federal Reserve System's monetary policymaking body.
Before becoming president in September of 2007, Evans served as director of research and senior vice president, supervising the Bank's research on monetary policy, banking, financial markets, and regional economic conditions.
His personal research has focused on measuring the effects of monetary policy on U.S. economic activity, inflation, and financial market prices and has been published in peer-reviewed journals.
Evans is active in the civic community. He is a trustee at Rush University Medical Center, a director of the Chicago Council on Global Affairs, a member of the Economic Club of Chicago board of directors, and a member of the Civic Committee of the Commercial Club of Chicago and Civic Consulting Alliance board.
Evans has taught at the University of Chicago, the University of Michigan, and the University of South Carolina. He received a bachelor's degree in economics from the University of Virginia and a doctorate in economics from Carnegie-Mellon University in Pittsburgh.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on September 9, 2022, at the third annual Exploring Career Pathways in Economics and Related Fields conference, cosponsored by the Federal Reserve Bank of Chicago and the Sadie Collective.
President Charles Evans joined the College of DuPage for a moderated Q&A on the U.S. economy followed by an audience Q&A.
President Charles Evans will join the Greater Des Moines Partnership and Drake University for a moderated Q&A on the U.S. economy followed by an audience Q&A.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on June 22, 2022, at the Corridor Business Journal Mid-Year Economic Review in Cedar Rapids, IA.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on May 17, 2022, to the Money Marketeers of New York University, Inc., in New York City, NY.
President Charles Evans joined Peterson Institute president Adam Posen for a fireside chat on economic and monetary policy followed by an audience Q&A.
President Charles Evans participated in a moderated Q&A during an event at the Economic Club of New York.
President Charles Evans participated in a moderated Q&A during an event at the Detroit Economic Club.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on April 1, 2022, at the Prairie State College Foundation’s annual Economic Forecast Breakfast in Olympia Fields, IL.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on March 24, 2022, at the Detroit Regional Chamber’s 2022 State of the Region event in Detroit, MI.
President Charles Evans participated in a moderated Q&A followed by an audience Q&A during the Lake Forest-Lake Bluff Rotary Club Economic Update on Wednesday, March 2.
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on February 18, 2022, at the 2022 US Monetary Policy Forum, sponsored by the Initiative on Global Markets at the University of Chicago Booth School of Business, in New York City, NY.
President Charles Evans participated in a moderated Q&A with the Milwaukee Business Journal on Thursday, January 13, at 12:00 p.m. CT.
President Charles Evans will participate virtually in a moderated Q&A followed by an audience Q&A at the 2021 BKD Financial Services Symposium on Thursday, November 18, at 1:00 p.m. CT.
President Charles Evans participated virtually in a moderated Q&A with the Mid-Size Bank Coalition of America on Wednesday, November 17, at 3:00 p.m. CT.
A speech presented virtually by Charles Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on November 8, 2021, at the Original Equipment Suppliers Association (OESA) 2021 Automotive Supplier Conference: Beyond Disruption in Novi, MI.
A speech presented on September 27, 2021, at the 63rd National Association for Business Economics (NABE) Annual Meeting in Arlington, VA.
President Charles Evans participated virtually in a moderated Q&A with Princeton University’s Markus Brunnermeier of the Bendheim Center for Finance on Thursday, September 30.
A speech presented virtually on September 9, 2021, at Exploring Career Pathways in Economics and Related Fields, cosponsored by the Federal Reserve Bank of Chicago and the Sadie Collective.
Charles Evans, President and CEO of the Federal Reserve Bank of Chicago, will participate virtually in a moderated discussion during the Thirteenth Annual Rocky Mountain Economic Summit on Thursday, July 15 at 10 a.m. CT.
CFA Society Chicago’s Distinguished Speaker Series: President Charles Evans
March 3, 2021 recording of President Charles Evans' moderated conversation with CFA Society Chicago. President Evans spoke on “The Current State of the Economic Recovery.”
Panel remarks presented virtually on May 25, 2021, at the 2021 Bank of Japan–Institute for Monetary and Economic Studies Conference, Adapting to the New Normal: Perspectives and Policy Challenges after the COVID-19 Pandemic.
President Charles Evans participated in a fireside chat with Mark Hamrick, Washington bureau chief for Bankrate.com, hosted by the Society for Advancing Business Editing and Writing on Monday, May 10.
A speech presented virtually on May 5, 2021, at the 29th Annual Hyman P. Minksy Conference on the State of the US and World Economies: Prospects for the US and Europe in an Emerging Post-Pandemic Recovery, organized by the Levy Economics Institute of Bard College.
A speech presented virtually on April 7, 2021, at the Prairie State College Foundation’s annual Economic Forecast Breakfast.
President Evans participated in a moderated discussion with the Women in Housing and Finance organization on March 25, 2021.
A virtual moderated discussion between President Evans and the Japan America Society of Chicago. The event took place on March 24th.
A speech presented virtually on February 3, 2021, to the Oakland University School of Business Administration, Department of Economics, in Rochester, MI.
A virtual moderated discussion presented on January 7, 2021, at the Wisconsin Bankers Association Midwest Economic Forecast Forum.
A speech presented virtually on January 5, 2021, for Federal Reserve Actions During the Coronavirus Pandemic, a panel hosted by IBEFA (International Banking, Economics, and Finance Association) and the AEA (American Economic Association) at the ASSA (Allied Social Science Associations) 2021 Annual Meeting.
A speech presented virtually on January 4, 2021, for Economic Prospects and Policies After COVID-19, a panel hosted by NABE (National Association for Business Economics) at the ASSA (Allied Social Science Associations) 2021 Annual Meeting.
A moderated discussion with Rann Paynter, President and CEO, Michigan Bankers Association (MBA).
A moderated discussion with Abe Tubbs for the Iowa Bankers Association (IBA) Leaders Speakers Series 2020.
A speech presented virtually on October 7, 2020, to the Metals Service Center Institute.
A speech presented virtually on October 5, 2020, at the 62nd National Association for Business Economics Annual Meeting.
A speech presented virtually on September 24, 2020, at the Illinois Chamber of Commerce Annual Meeting.
A speech presented virtually on September 3, 2020, to the Lakeshore Chamber of Commerce in Hammond, IN.
A speech presented virtually on June 24, 2020, at the Corridor Business Journal Mid-Year Economic Review.
A speech presented virtually on May 11, 2020, to the Lansing Regional Chamber of Commerce in Lansing, Michigan.
A summary of a presentation delivered on February 27, 2020, at the Central Banking Conference sponsored by the Global Interdependence Center and Banco de México in Mexico City, Mexico.
Opening remarks presented on January 3, 2020, at the Allied Social Science Associations 2020 Annual Meeting in San Diego, California.
A speech presented on November 14, 2019, at the Third Annual Fintech Conference in Philadelphia, PA.
A speech presented on October 17, 2019, at Fed Listens: Monetary Policy’s Impact on Workers and Their Communities in Chicago, IL.
A speech presented on October 16, 2019, before the Greater Peoria Economic Development Council in Peoria, IL.
A speech presented on October 1, 2019, at the Global Interdependence Center (GIC) Central Banking Series event, Monetary and Economic Policies on Both Sides of the Atlantic, in Frankfurt, Germany.
A speech presented on September 4, 2019, at Forging a New Path for North American Trade: The Auto Sector, a conference in Detroit, MI.
A speech presented on June 4, 2019, at the Fed Listens Conference on Monetary Policy Strategy, Tools, and Communication Practices in Chicago, IL.
A speech presented on May 9, 2019, at the Federal Reserve System Community Development Research Conference, Renewing the Promise of the Middle Class, in Washington, DC.
A summary of a presentation delivered on May 6, 2019, at the Bank of Italy in Rome, Italy.
A speech presented May 3, 2019, at the National Association for Business Economics (NABE) and Sveriges Riksbank conference, Global Economies at the Crossroads: Growing Together While Growing Apart?, in Stockholm, Sweden.
A speech presented April 15, 2019, at the New York Association of Business Economists (NYABE) Economic Luncheon in New York, NY.
A speech presented on March 25, 2019, at the 2019 Credit Suisse Asian Investment Conference in Hong Kong.
A speech presented on January 10, 2019, at the Milwaukee Business Journal Economic Forecast in Milwaukee, WI.
A speech presented on January 9, 2019, at the Discover Financial Services Company Meeting in Riverwoods, IL.
A speech presented on October 29, 2018, before the sixth annual Summit on Regional Competitiveness in Chicago.
A speech presented on October 9, 2018, before the Opportunity Finance Network in Chicago.
A speech presented on October 3, 2018, before the OMFIF City Lecture on the U.S. Economic Outlook in London, UK.
A speech presented on September 14, 2018, before the Northeast Indiana Regional Economic Forum in Fort Wayne, IN.
A speech prepared for September 3, 2018, for the Central Bank of Argentina Money and Banking Conference, Dealing with Monetary Policy Normalization, in Buenos Aires, Argentina.
A speech delivered on May 25, 2018, before the joint Federal Reserve Bank of Atlanta and Federal Reserve Bank of Dallas conference, Technology-Enabled Disruption: Implications for Business, Labor Markets and Monetary Policy, in Dallas, TX.
A speech delivered on May 7, 2018, before the Federal Reserve Bank of Atlanta Conference, Machines Learning Finance. Will They Change the Game?, in Amelia Island, FL.
A speech delivered on September 8, 2017, before the World Federation of Exchanges Annual Meeting in Bangkok, Thailand.
Comments delivered on March 3, 2017, before the 2017 U.S. Monetary Policy Forum in New York, NY.
Thank you for that kind introduction and for making me feel welcome in Hong Kong. Though I've been here only a short time, I find it easy to see why this unique city has become so important to the financial services industry throughout the world. I'd also like to thank Christopher Rogers and the Institute of Regulation & Risk for their kind invitation. It was that invitation that prompted my thinking in putting together this two-week visit to China. I know other Federal Reserve presidents have participated in this event in the past, and I am pleased to add my name to that list and the list of distinguished panelists who have joined us here tonight.
We are slowly emerging from the worst financial crisis since the 1930s. The hardships created by these exceptional circumstances for households and businesses are well known. Governments and regulators around the world have responded to the crisis with a variety of aggressive and innovative policy actions, including giving special assistance to specific institutions.
Now, as we slowly emerge from the crisis, we are engaged in a vigorous debate on how best to address the major weaknesses in our financial regulatory framework that were revealed by the crisis. Our goal, clearly, is to avoid another crisis of this magnitude. Financial reform will not be easy. We face complex problems that will require a comprehensive, multi-pronged approach. But reform is critical for ensuring our long-term economic stability.
Today, I would like to offer my thoughts on some of the reform proposals that are being discussed. I should note that my remarks reflect my own views and are not those of the Federal Open Market Committee or the Federal Reserve System.
To highlight some of the changes that are being considered, there are proposals that would assign monetary policy a more active role in fighting asset bubbles; proposals that would strengthen current microprudential regulations; proposals that would introduce a systemic regulator and macroprudential regulations; and proposals that would create resolution authority – particularly for systemically important financial institutions.
Time does not permit me to discuss the specifics of each of these proposals today. Instead, I would like to offer my thoughts on some of the challenges we are likely to face in implementing even the most well-thought-out policies.
Let me be clear. I don’t bring up these potential challenges as roadblocks to the healthy debate that is underway. Rather, I offer them as issues we need to consider as we build a better financial infrastructure.
One preemptive action that is being debated concerns the role of monetary policy in combating asset bubbles. Given the rapid rise in some asset prices prior to the recent crisis, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may be emerging and to raise their target rates in order to lower asset prices that, by historical standards, seem unusually high. In previous forums, I have discussed why I view these proposals with skepticism.1 I won’t cover the same ground here again. Instead, let me just note that I am skeptical about our ability to easily and definitively sort out in real time whether a rapid increase in asset prices is associated with overvaluation. That is, how confidently can we state that we are in the midst of a bubble? I also think that monetary policy is too blunt a tool for pricking bubbles: It can’t be targeted precisely and it will affect other financial and macroeconomic variables in addition to the suspected bubble asset. In addition, the typical changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices.
Fortunately, monetary policy is not the only tool that policymakers have to deal with financial exuberance. In my view, redesigning regulations and improving market infrastructure offer more promising paths. Regulation may or may not be sufficient to avoid all of the events that create crises, but it should go a long way toward doing so. Better supervision and a sound regulatory infrastructure can also increase the resiliency of markets and institutions and their ability to withstand adverse shocks that do occur.
How do we promote such resiliency?
Within the existing structure, regulators have the ability to promote better, more resilient financial markets, either through rule-making or by serving as a coordinator of private initiatives. They can also encourage more and better disclosure of information—a key element of effective risk management. A number of initiatives along these lines have been taken and additional ones are being considered.2
We can use existing regulatory tools more effectively, but we also need to address the shortcomings of current regulations. The ongoing work of the Basel Committee on Banking Supervision regarding the possible introduction of liquidity standards and adjustments to the existing capital requirements are examples of such efforts.
While such enhancements to micro-prudential regulations are necessary, I would argue that they are not close to being sufficient to address the complex issues we faced during the recent crisis. Success in preventing and controlling potential risks requires very early and courageous action by policymakers. Typically, risks and problems in the financial system build over a number of years. There is an awful amount of uncertainty as to whether risks are developing; how they will be perpetuated; and when to take action. Microprudential regulations alone are not likely to resolve these issues.
Let me illustrate the sort of problems a microprudential regulator faces with a specific example. As you know, the problems with residential mortgages, particularly with subprime mortgages, were one of the key areas that precipitated the current crisis. Currently, the U.S. financial system faces problems with commercial real estate (CRE) loans. At the end of 2009, depository institutions in the U.S. held over $1.5 trillion in commercial real estate and construction loans on their books. In addition, there are currently nearly $800 billion in commercial mortgage-backed securities (CMBS) outstanding. Over the past two years, delinquencies on these loans and securities have been rising at an uncomfortably rapid rate. Figure. 1 Of the over $1 trillion in commercial real estate loans held by depository institutions today, nearly 4 percent are noncurrent.3 This ratio was about 0.5 percent before the crisis (June 2007). The picture is even worse for the riskier construction and land development loans. While these loans total less than $0.5 trillion, the noncurrent portion had risen from 1.5 percent at the end of June 2007 to nearly 16 percent by the end of last quarter. For CRE loans packaged into securities, serious delinquencies represent 4 percent of all CMBS currently outstanding, up from nearly zero before the crisis.
Does such a fast rise in CRE and CMBS delinquencies mean that bank examiners missed clear signs of forthcoming problems and failed to take action? Commercial real estate loans are a key problem area for the banks in my District. I went to my supervisory staff and said: “I know you are struggling with commercial real estate loan portfolios. What are the difficulties? What do you think we needed to have done in the past in order to avoid the current problems?”
I have to admit that their response made me pause. They said “You know, Charlie, if we wanted to avoid the current situation, we needed to act very, very early – probably in 2004 or 2005.” That is a full two to three years before the onset of problems in the sector. Clearly, we needed to act very early. But at that time, it would have been difficult to argue convincingly in favor of reigning in this lending. The economy was coming out of the jobless recovery and just beginning to gain traction. And the banking industry had proven it could maintain profits through a recession, it had reduced problem loans back to historically low levels, and it appeared to have more than sufficient capital to cushion against potential losses.4
Given previous problems with commercial real estate loans, my supervisors understood the potential risks. Here is a typical situation they faced. Imagine you are an examiner and you go out to review a large financial institution in 2005. The institution is warehousing commercial real estate loans prior to securitization during a period when CMBS issuance is just taking off and, for every $1,000 in CRE loans, only $6 are noncurrent. Nonetheless, as an examiner, you have a discussion with the bank managers and you learn about their lending practices, and you kind of wonder, “How well-controlled is all of this?”
The loan officers will give you some very good arguments about what their business is and how the risks are being controlled. First, they are not really storing the loans on their books. They are underwriting the loans with the full intention of packaging them into securities. They have to build up a critical mass before securitization, but they are not going to keep the loans.
From the banks’ perspective, they are not in the storage business. They are in the transportation business. It is rather short term – 60, 90 days. Presumably, the risk is only proportional to how long they are holding on to it – which is not very long. Furthermore, during this period, real estate prices are going up, delinquencies are negligible, and banks have a variety of hedges in place. They look at commercial real estate prices and think, if needed, they can get out of their portfolio at little cost. And even if some losses materialize, they have adequate capital.
I have some interesting people on my staff who can push back in a pretty challenging fashion. But at the end of the day, after carefully considering the banks’ arguments, they think: “All right, I guess the loan officers are looking at this pretty reasonably and are protecting their institution.” And the risk to the deposit insurance fund from all this activity seems pretty small. So, you end up being convinced that the activity is probably OK.
Today, with hindsight, we know that while most of the micro risks appeared very small at the time, their sum was far less than the macro risk that was silently building up. That’s the key thing: A collection of negligible micro risks can add up to a far greater macro risk. Focusing on individual institutions and controlling risks on a firm-by-firm basis are not enough for detecting and controlling systemwide stress points.
That is why we need macroprudential supervision and regulation.
Suppose for a particular class of assets, values decline on an economy-wide basis. This means losses are going to be taken at the macro level. Perhaps managers at a few individual banks can be smart, foresee the price declines, and liquidate their positions in time to avoid large losses at their institution. But the macro economy has to take these losses, and that’s where we get stuck. Not everyone can get through the exit door at once; someone has to end up bearing the macro losses.
This is why macroprudential regulations that aim to assess and control systemwide risks should play a critical role in our regulatory structure.
For instance, dynamic capital requirements and loan loss provisions that vary over the cycle can temper some of the boom–bust trends we have seen in the past. History shows that during boom times, when financial institutions are perhaps in an exuberant state, they may not price risks fully in their underwriting and risk-management decisions. During downturns, faced with eroding capital cushions, increased uncertainty, and binding capital constraints, some institutions may become overcautious and excessively tighten lending standards. Both behaviors tend to amplify the business cycle. Varying required capital loan loss provisions over the cycle could serve to offset some of this volatility.
We saw the advantages of a systemic, macroprudential approach firsthand during the implementation of the Supervisory Capital Assessment Program (SCAP) – the so-called “stress tests.” Last spring, the Federal Reserve led a coordinated examination of the largest 19 U.S. banks. We reviewed the institutions simultaneously, applying a common set of assumptions and scenarios across all of them. Such an approach provided us with a view of these banks in their totality, as well as the financial condition of individual institutions on a stand-alone basis. The horizontal view was essential in assessing how risks taken individually by each bank are correlated and how they can add up to more than the sum of individual components. The review also had a forward-looking element that assessed the likely condition of the banks under a specific set of adverse economic conditions and determined the amount of capital the banks would need under these “stress” conditions. Such procedures also enable supervisors to identify best practices in risk management and to push banks with weak controls to improve and adopt these industry best practices. Indeed, supervisors at the Federal Reserve have already begun to adopt such an approach.
However, even with such macroprudential strategies, we are going to face challenges. Let’s think about what, as a hypothetical macroprudential regulator, we would have to do. What should be the early call focus? What should we be looking at? When should we be looking at it? How confident are we that that we are actually going to be able to identify the problem? A macroprudential regulator is confronted with the same type of questions a microprudential regulator faces, but at a systemwide level.
Consider these questions within the context of commercial real estate. The facts are, today, CMBS and CRE loans have large delinquencies. Could anyone have made this call confidently in time to arrest the problems we face today?
On this slide Figure. 2, on the top panel, you see that the outstanding volume of CMBS ramps up in 2004, 2005. At the same time, commercial real estate prices (shown in the middle panel) continue to rise well into 2007. On the bottom panel, we see the performance of loans originated during this period, depending on when the loans were made. Loans originated later in the credit cycle are performing worse than older loans. For instance, loans underwritten in 2005 did not reach a 1 percent delinquency rate until about 42 months (3.5 years) after origination. In contrast, loans made in 2008 reached the 1 percent delinquency mark only six months after origination. The progressively worsening performance of loans originated later in the credit cycle is likely due to looser underwriting standards that supported the issuance boom.
With the benefit of hindsight, I can point to the inflection point in volume and say “I should have put my finger on that right then.”
At that point in the credit cycle, “shouting” would have been an important part of risk-control, as it would have emphasized potential risks to the market players.
But I can’t imagine that supervisors’ concerns would have been taken seriously in 2005 or 2006 -- even if they started going out and shouting to the heavens that there is a big, big problem and we need to do more about it. Recall that, at that time, real estate prices were ramping up and delinquencies were low. Indeed, in 2007, the Federal Reserve, along with other bank regulators, issued a supervisory guidance on concentrations in commercial real estate. 5 We also gave a number of speeches prior to the crisis about risk pricing and about market exuberance – to little avail. These warnings were largely ignored and we got a lot of push-back from banks. During boom periods when risks are silently building up, there are a lot of people with a lot of money at stake who will come out against such pronouncements. So, if policymakers do not follow words with actions, then we are not likely to make much progress. Shouting and supervision – together – are essential.
I raised some potential issues with both micro- and macro-prudential regulations.
How do we address these issues? This is where we would take full advantage of our multi-pronged approach to regulatory reform. If we are not certain that a particular approach may not be as effective as we would like, we can put more pressure on other levers to obtain a desired amount of risk control. So, if we think that macroprudential regulations may have some potential operational issues, we would need to implement more stringent capital and liquidity requirements than we would otherwise to overcome these issues.
This is why we need a multi-pronged approach to a robust regulatory structure: a structure that takes full advantage of the existing tools supervisors have ; a structure that supplements the existing one with dynamic capital requirements and a comprehensive approach to risk management ; a structure that includes a macroprudential supervisor than can monitor and assess incipient risks across institutions and markets and, when necessary, impose higher regulatory requirements on firms that pose systemic risks.
However, even with such a structure, it would be hubris on the part of policymakers to assume that we would be able to prevent financial stress at all financial institutions. Therefore, we also need to contain the disruptive spillovers that result from the failure of systemically important institutions without resorting to bailouts or ad hoc rescues. A necessary element of this is having a mechanism for resolving the failure of a systemically important institution.6 This is something we currently lack in many cases, though there are proposals now under discussion that would provide this resolution power.
Another issue that arises in the regulatory reform debate is whether the central bank should be entrusted with supervision and regulation responsibilities. There are many synergies between monetary policy and supervision and regulation that I and others have discussed in previous speeches.7 Let me point out a couple of reasons why it might be optimal for a central bank to have a key role in financial stability and regulation.
The reality is that central banks have the unique ability to act as the lender-of-last-resort during financial crises. The central bank cannot use this tool effectively if it is not knowledgeable about the financial condition of the institutions it might lend to, particularly if such loans need to be made at very short notice.
The lender-of-last-resort role inevitably thrusts the central bank into efforts to promote financial stability and avoid crises. If, however, central banks have no supervision and regulation tools, they are constrained to act with the only tool at their disposal – monetary policy.
I already mentioned that I am skeptical about using monetary policy to control financial exuberance. But without supervisory powers, there may be no choice. We know that time consistency issues can lead a central bank to choose inflationary outcomes in the short run, even though there is no long-run tradeoff between output growth and price stability. Ken Rogoff pointed out that one way to deal with this issue would be to appoint a conservative central banker who would be tougher than the public. This would ensure that appropriate decisions would be made and appropriate actions would be taken
Now, consider the reaction function of a central banker that has the additional responsibility for financial stability – but not the additional tools provided by a supervision and regulation role. Such a central banker might have to act against exuberance in financial markets more actively than it would otherwise. That would be entirely necessary and appropriate to preserve financial stability. However, that policy may not be the most appropriate one at that time for addressing the traditional goals of monetary policy of maximum sustainable employment and price stability. A central bank with three goals and only one lever is a recipe for producing some difficult policy dilemmas.
To sum up, it is clear that, in order to avoid a situation like the one we have faced in the past two years, we need to fortify our regulatory lines of defense. We need to change the rules of regulation to be more efficient and effective in their design and implementation. But we also need to openly acknowledge the challenges policymakers and regulators are likely to face in containing potential financial crises. Despite all the challenges, I believe that we can design a more effective regulatory structure through discussions such as the one we are having today.
1 For instance, see Evans (2009a and 2009b).
2 For instance, in recent years, regulators have actively supported the development of the Trade Information Warehouse (a central repository for trade reporting of over-the-counter credit derivatives contracts) and clearing houses for credit default swaps, such as ICE Trust.
3 Noncurrent loans are those that are 90 days or more past due plus loans in nonaccrual status.
4 At the end of 2004, return on equity at all commercial banks in the U.S. was 13.08 percent, near its historical peak of 16.23 percent in the second quarter of 1993. Return on assets were similarly high, and net charge-offs accounted for only 0.68 percent of total loans, well below 1.31 percent reached at the end of 2001.
5 See, “SR 07-1 Interagency Guidance on Concentrations in Commercial Real Estate” available online. More recently, the Federal Reserve issued a supervisory guidance on managing interest rate risk (“SR 10-1 Interagency Advice on Interest Rate Risk,” available online) and highlighted it in speeches (for instance, see Kohn (2010)). In addition, the Federal Reserve – along with the other Federal banking agencies – issued a policy statement on funding and liquidity risk management on March 17, 2010 (available online).
6 See Evans (2009c) for my views on the advantages of resolution authority and the issues it would address.
7 For instance, see Bernanke (2010), Evans (2010), Kashyap (2010), and Volcker (2010).
Bernanke, Ben S., 2010, The Federal Reserve’s Role in Bank Supervision, Testimony before the U.S. House Committee on Financial Services, Washington, DC, March 17.
Evans, Charles L., 2009a. “The International Financial Crisis: Asset Price Exuberance and Macroprudential Regulation.” Remarks given at the 2009 International Banking Conference on September 24, 2009 in Chicago, IL. Available online.
Evans, Charles L., 2009b. “Should Monetary Policy Prevent Bubbles?” Remarks given at the &Asset Price Bubbles and Monetary Policy Conference on November 13, 2009 in Paris, France. Available online.
Evans, Charles L., 2009c. “Too-Big-To-Fail: A Problem Too Big to Ignore” Remarks given at the European Economics and Financial Center on July 1, 2009 in London, England. Available online.
Evans, Charles L., 2010a. CFA Society of Chicago Distinguished Speaker Series: Luncheon Economic Forecast. Remarks delivered on March 4, 2010 in Chicago, IL. Available online.
Evans, Charles L. 2010b, CFA Society of Chicago Distinguished Speaker Series: Luncheon Economic Forecast, March 4. Available online.
Kashyap, Anil K, 2010 Examining the Link between Fed Bank Supervision and Monetary Policy, Testimony before the House Financial Services Committee, March 17. Available online.
Kohn, Donald L., 2010. “Focusing on Bank Interest Rate Risk Exposure.” Remarks delivered at the Federal Deposit Insurance Corporation’s Symposium on Interest Rate Risk Management on January 29, 2010 in Arlington, Virginia. Available online.
Volcker, Paul, 2010, Statement, Testimony before the House Financial Services Committee, March 17. Available online.
Good morning. It is a pleasure to be with you today. This year’s conference, and the topics being discussed, are of great importance to us all—economists, regulators, market participants and policymakers. We share a common interest in fostering the economic recovery and a return to strong growth in an environment of low and stable inflation. Conferences such as this one bring together diverse perspectives that will help in devising solutions to achieve these goals.
Today I would like to discuss a few challenging issues that the labor market presents for monetary policymaking. For a bit of context, let me say that I approach this from not just the perspective of a Fed bank president, but also of a macroeconomist and former Fed research director. I’ve had the benefit of attending FOMC meetings since 1995. I have observed firsthand some of the conflicts that FOMC members face in addressing the Fed’s dual mandate to promote maximum employment and price stability even in more normal times. For me, price stability is 2 percent inflation as measured by the Personal Consumption Expenditures (PCE) deflator over the medium term. When I became Chicago Fed president in 2007, I never would have guessed that my first 2-1/2 years would have me voting continually for lower interest rates and more policy accommodation. But with the unemployment rate at 9.7 percent and inflation significantly under my benchmark for price stability, there is no conflict between our policy goals, and so the directions for policy have been clear. Today, I will highlight a number of labor market issues that lead me to think this accommodation will likely be appropriate for some time.
Let me emphasize that the views that I am presenting today are my own and not necessarily those of the Federal Open Market Committee (FOMC) or my other colleagues in the Federal Reserve System.
I find myself in broad agreement with the view that restrictive bank credit, along with business and household caution, will continue to restrain the recovery’s strength but that these headwinds will abate as we move through 2010. Most business cycle indicators have turned favorable already. Yet many households and businesses remain wary that a full-fledged recovery is in train. That is not surprising. As we all know, employment is often the last piece of the puzzle to fall into place, and until the economy begins to add jobs in significant numbers, for many it will not feel like much of a recovery.
The latest reports on this front have been mixed. Layoffs are subsiding. Firms are hiring more temporary workers, and after a large decline, the average workweek is showing signs of stabilizing and perhaps reversing course. These developments usually are precursors of a broader scale recovery in labor demand. But, today, employers remain cautious. Job openings are still scarce, and there are few signs, even anecdotally, that permanent hiring has picked up yet. Moreover, even once labor markets turn the corner, there is a long ways to go before they get back to what we would consider to be normal.
The ongoing weakness in labor markets—and memories of the jobless recoveries from the previous two recessions—have raised concerns that something has fundamentally changed in the way labor markets work. Some worry that they have deteriorated more than would be expected given the declines in output during the recession and, in turn, this additional weakness might impinge on the speed of the recovery moving forward.
Headline unemployment numbers are consistent with the recession
The usual starting point for thinking about this issue is Okun’s famous “law” relating gross domestic product (GDP) growth to the change in the unemployment rate. The usual estimates of Okun’s law imply that the unemployment rate should be at least a percentage point lower than the 9.7 percent we actually saw last Friday.
However, this calculation assumes that the association between economic activity and the unemployment rate does not vary across the business cycle. In fact, many employment indicators tend to deteriorate faster during recessions than they improve during expansions. A simple statistical model that uses the historical relationship between GDP growth and unemployment estimated only during recessions can actually account for the sharp rise in the unemployment rate. Figure 1 compares the actual unemployment numbers (the blue line) to their predicted values from models estimated using GDP data only from recessions (the red line). The two lines are just about spot on. But the green line—the prediction from a standard model that does not distinguish between behavior in expansions and recessions—is not capable of capturing the current numbers. Similar “recession-only” models can also explain the rise in broader measures of unemployment and “underemployment” like the U.S. Bureau of Labor Statistics’ U-6 rate, as well as the declines in payroll employment.1
Based on these exercises, I think that it is reasonable to conclude that the unemployment rate and employment growth have evolved about as we would expect given the severity of this recession.
But other labor market measures are weaker than expected
Once you look past the headline numbers, however, some other labor market indicators are unusually weak. In particular, the share of adults who are outside the labor force has increased more, and the average length of a spell of unemployment has grown much longer than predicted by even our “recession-only” models.
I would like to spend some time elaborating on the implications of the increase in unemployment duration. Much of this material will be appearing in a forthcoming article by my colleagues at the Chicago Fed, Dan Aaronson, Bhash Mazumder, and Shani Schechter. The consequences of long-term unemployment on households can be quite severe. Such households, especially those with little or no wealth, are susceptible to sharp falls in consumption. Moreover, long-term unemployment often leads to a significant loss in permanent earnings even after the worker finds a new job.
Unemployment duration has risen at an unprecedented rate over the past year or so. In February, over 40 percent of the unemployed were in the midst of a spell lasting more than six months, by far the highest proportion in the post-World War II era.
You can see this in Figure 2, which plots from 1948 to the present the relationship between the unemployment rate (x-axis) and the average length of an ongoing spell of unemployment (y-axis). The red dots represent the monthly figures for 2008 and 2009. At the beginning of the recession, the unemployment rate was at 5 percent and the average unemployment duration was about 17 weeks. Duration was already about 4 weeks more than what would be predicted based on the average historical relationship, represented by the black regression line, between the two measures. This divergence is largely accounted for by a secular shift toward longer spells of unemployment due to the aging of the work force and the much stronger labor force attachment of women.
In the first 15 months of the recession, average duration increased with unemployment at roughly the rate you would have expected. This is indicated by the series of red dots that fall along the top of the blue cloud and are parallel to the black line. But since the first quarter of 2009, average duration has increased much more rapidly than the rise in the unemployment rate would predict.
The extension of unemployment insurance benefits, while helpful in supporting unemployed households, likely accounts for a portion of the recent rise in unemployment duration.2 Even so, we view the overall magnitude of the increase as an indicator that labor market conditions are even bleaker than the unemployment rate alone suggests. This weakness may also explain why the share of those outside the labor force has also grown so much—many people have simply stopped searching for jobs given the lack of demand for their services at prevailing wages.
Implications of rising long-term unemployment on the outlook
The rise in long-term unemployment may have ramifications for the economy going forward. The likelihood of finding a job tends to decline as an individual remains out of work for a longer period. Partly this reflects the fact that those who typically have a difficult time finding work will tend to be unemployed longer. In this case, longer spells are a symptom rather than the source of an underlying problem. However, a long unemployment spell could itself cause deterioration in a worker’s skills, leaving some of the long-term unemployed with less bright job prospects even as the economy begins to revive. This could contribute to high average unemployment duration for some time.
We can gain some insight into this dynamic from earlier periods. Figure 3 highlights the path of the unemployment rate and duration during the last two severe recessions. As you’d expect, both measures rise in tandem during the recession. But during the recovery phase, unemployment duration remains persistently high for quite some time even as the unemployment rate declines. We expect to see a similar pattern in the near future. And as I noted earlier, long-term unemployment tends to lead to permanent earnings losses, particularly for those who have previously invested heavily in job- or industry-specific skills. So, high unemployment durations could have long-lasting effects on consumer confidence and demand.
To summarize this discussion of the labor market, headline employment indicators appear to be roughly following a conventional track given the severity of the recession. But these measures may not fully capture the weakness displayed in the rising unemployment duration and the withdrawal of workers from the labor force. These developments thus raise the risk that the recovery in labor markets could be slow even as output returns to a well-established growth path.
Productivity and resource slack
The other side of an economy experiencing growing output but low labor utilization is high productivity growth. Indeed, productivity has been quite strong of late, particularly over the past three quarters. This is often the case in the early stages of a recovery, as firms first meet higher demand for their products and services without expanding their work force.
A key question today is the degree to which the recent productivity surge reflects a temporary cyclical development or a more enduring increase in the level or trend rate of productivity. If the gains are predominantly driven by intense cost cutting, then they may be unsustainable once demand revives more persistently. In this case, we would expect hiring to pick up quickly as the economic expansion takes hold. However, if the level or trend in productivity has risen due to technological or other improvements, then higher average productivity gains will continue. In this case, the implications for hiring are not clear. Higher levels of productivity will show through in both higher potential and actual output for the economy, and so need not necessarily come at the cost of lower labor input.
The relative importance of these factors also has consequences for our assessment of the degree to which resource slack exists in the economy. Since a higher level or trend of productivity implies a higher path for potential output, a given level of actual GDP would also be associated with a greater degree of economic slack. That is, the good news on productivity, if sustained, suggests that as of today we have a larger output gap to fill In contrast, some are skeptical that the economy really is operating far below sustainable levels. They argue that much of the drop in output during the recession was the result of a permanent reduction in the economy’s productive capacity, perhaps because certain financial market practices that had for a time enabled additional investments have now been discredited. According to this view, the strong productivity growth of recent quarters only goes a fraction of the way toward offsetting this decline in the level of potential output.
Of course, the unemployment rate gives us another way to infer the degree of slack in the economy. My earlier discussion of the sharp rise in unemployment duration and decline in labor force attachment may lead one to think that slack is even greater than what is implied by the unemployment rate itself.
However, it is possible that longer durations and lower labor force attachment could reflect broader structural changes in the economy, such as a mismatch between the skills of the unemployed and those demanded by employers. There may also be other impediments that currently prevent workers from shifting to the industries or locations where jobs are available. Under these scenarios, labor market slack might actually be lower than what one might infer from the unemployment rate alone.
I have just given you 2 minutes of classic two-handed economist speak. In the final analysis, however, the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy. Incorporating alternative views about productivity and labor market behavior do not alter this general conclusion. The debate really boils down to whether the amount of slack in the economy is large or is extremely large.
Should the Fed have done more?
Given this large degree of slack, there is a legitimate question of whether monetary policy could, and more fundamentally should, have done more to combat the deterioration in labor markets. As we all know, a lot was done. As the crisis arose, we first used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount window. As we neared a zero funds rate, we turned to nontraditional tools to clear up the choke points, providing liquidity directly to nonbank financial institutions and supporting a number of short-term credit markets. Finally, we reduced long-term interest rates further by purchasing additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of government-sponsored enterprises.
These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction. But the unemployment rate still hit 10 percent this fall.
Had we done more, the most plausible action would have been to expand our Large Scale Asset Purchases (LSAP) program. Precisely quantifying the effect this would have had is difficult. A good place to start, though, is to look at the recent empirical evidence.3 When significant new asset purchases were announced, our big, fluid financial markets built that information immediately into asset prices. For example, right after the March 2009 Treasury purchase announcement, ten-year Treasury yields fell about 50 basis points. Comparable declines occurred in Option Adjusted Spreads (OAS) on the announcement of agency mortgage-backed securities (MBS) purchases in November 2008. It might be reasonable to infer that say, doubling the size of the LSAPs might have doubled this impact on rates.
However, I would attach more than the usual amount of uncertainty to such an inference. Part of my hesitation reflects our lack of understanding about the interactions between nontraditional monetary policy, interest rates, and economic activity. While research efforts at the Federal Reserve and elsewhere to assess the effects of nonstandard monetary policy have been ramped up considerably, to date we do not have a robust suite of formal models to reliably calibrate interventions of this sort.
Moreover, there are reasons to expect that the impact of recent nontraditional policy actions might not have scaled up so simply. We initially responded to the financial crisis with our highest-value tool—a reduction in the funds rate—and then moved to our best alternative policies as interest rates approached zero. Finally, we turned to the LSAPs, which were designed to further lower long-term interest rates and thus stimulate demand for interest-sensitive spending, such as business fixed investment, housing, and durables goods expenditures. But the influence of lower rates on private sector decision-making may have reached the point of second-order importance relative to the countervailing forces of the housing overhang, business and household caution, and considerably tighter lending standards.
Moreover, although it is impossible to quantify, a portion of the impact of our nontraditional actions may have come simply from boosting confidence. In those very dark times, I believe households, businesses, and financial markets were reassured that policymakers were acting in a decisive manner. Further asset purchases would not have had an additional effect of this kind.
In addition, on a practical level, the portfolio of future purchases likely would have looked different and therefore their overall effectiveness might have deviated from our recent experience. The Fed’s typical monthly purchases of new issuance MBS were so large that it left very little floating supply for private investors. This could have forced a larger LSAP program to concentrate more heavily in Treasuries or existing MBS. Though the empirical evidence is limited, these assets likely are less close substitutes than new MBS for many of the instruments used to finance spending on new capital goods, housing, and consumer durables. Consequently, the effect of their purchase on economic activity may be less.
Finally, we must also keep in mind that more monetary stimulus also has costs. These could be considerable at higher LSAP levels. Many are already worried about the inflation implications of the Fed’s expanded balance sheet and the associated large increase in the monetary base. Currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those reserves, they are not generating spending pressure. But leaving the current highly accommodative monetary policy in place for too long would eventually fuel inflationary pressures. Likewise, if the monetary base was expanded much beyond where we are today, the risk that such pressures would build as the economy recovers would be significantly increased. Furthermore, policymakers already face the task of unwinding a sizable balance sheet at the appropriate time and pace. Substantially increasing the size of asset purchases could have further complicated the exit process down the road.
That said, changes in economic conditions could alter the cost–benefit calculus with regard to the LSAP. Hopefully the recovery will progress without any serious bumps in the road and the inflation outlook will remain benign. But, as we have repeatedly indicated in the FOMC statements, the Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.
1 For further details, see Aaronson, Brave, and Schechter (2009).
2 Aaronson, Mazumder, and Schechter (2010) apply estimates from Katz and Meyer (1990) and Card and Levine (2000) of the elasticity of increases in the maximum eligibility time for unemployment insurance benefits on the duration of unemployment to the current context. These calculations suggest that federal extensions may account for between 10 percent and 25 percent of the observed rise in mean durations from July 2008 through December 2009. Some caution should be applied to these estimates, since they rely on strong assumptions.
3 See Sack (2009) as well.
Aaronson, Daniel, Scott Brave, and Shani Schechter, 2009, “How Does Labor Adjustment in this Recession Compare to the Past,” Chicago Fed Letter, June.
Aaronson, Daniel, Bhashkar Mazumder, and Shani Schecter, 2010, “An Analysis of the Rise in Long-Term Unemployment”, forthcoming, Economic Perspectives.
Card David and Phillip B. Levine, 2000, “Extended Benefits and the Duration of UI Spells: Evidence from the New Jersey Extended Benefit Program”. Journal of Public Economics, 78(1-2), 107-138.
Katz, Lawrence F. and Bruce D. Meyer, 1990, “The Impact of the Potential Duration of Unemployment Benefits on the Duration of Unemployment”. Journal of Public Economics, 41(1), 45-72.
Sack, Brian, “ The Fed’s Expanded Balance Sheet,“ Remarks given at New York University, December 2, 2009.
Thank you for that warm introduction. It’s just over two years since I became president of the Federal Reserve Bank of Chicago, and I am reminded that one of my first public speaking engagements was to this group in February of 2008. You'll recall that my remarks that day were made as the world financial crisis was in its early stages. In fact I spoke to you just before the collapse of Bear Stearns in mid-March.
So much has happened since then, not the least of which is the fact that the crisis and the actions of the Federal Reserve in helping to resolve it have become a staple for the news media worldwide. In fact, it's almost impossible to read a newspaper or watch television without hearing something about the Fed, the economy, and the financial crisis.
As I have travelled around the country making speeches over the past few months, I find myself being asked the same three questions over and over again. So for my prepared remarks today, I’d like to address those big questions about the economy. Afterwards, I’ll also give you an opportunity to ask some questions of your own.
Let me emphasize that the views that I am presenting today are my own and not necessarily those of the Federal Open Market Committee (FOMC) or my other colleagues in the Federal Reserve System.
Let’s begin with the question I am asked more frequently than any other: Is the recession really over? In a narrow, technical sense, the short answer is yes. Many broad indicators of economic activity are increasing as we would expect in the early stages of a recovery. Nonetheless, I keep hearing the question because many households and businesses do not yet feel like they are in much of a recovery. Unemployment remains very high, and many businesses are still producing and selling much less than they did two years ago. What people really want to know is when will we make significant progress in returning unemployment and other measures of economic health to more normal levels? We appear to be moving in that direction, but there is much work to be done.
Let me elaborate a little on those points. Although 2009 started as a very weak year, it finished well. Real gross domestic product (GDP), our broadest measure of economic output, increased at a 4.1 percent rate in the second half of last year. A portion of this improvement reflects the effects of government stimulus spending. But private demand is beginning to firm up as well. For example, in the automobile industry, which was hit especially hard by the recession, sales have held up in recent months even after the cash-for-clunkers program ended. In other industries, many firms that cut production and inventories very aggressively during the recession are now dialing back their inventory liquidation. On balance, the latest data on manufacturers’ orders have been more positive, both for materials and parts and for capital equipment. Demand from abroad is also increasing; in particular, the emerging-market economies are showing renewed vigor that should benefit U.S. exporters.
In the housing market, the news has been mixed. Sales of new homes and housing starts stopped falling early last year and have been bouncing along without much of a trend over the past several months. Sales of existing homes increased a good deal through most of 2009, but much of the gain was retraced around the turn of the year. Subsidies for first-time home buyers have contributed to the ups and downs in the data, and we have yet to see how well the housing market will hold up once they ultimately expire. However, the declines in home prices that earlier precipitated the financial crisis are now attracting buyers, and so are low mortgage rates. Sadly, many of these sales are for foreclosed homes, but at least they are now moving on the market. Last year's sales and the low level of starts have substantially helped to reduce the overhang of unsold homes, which should help set the stage for a gradual recovery in residential construction.
Most forecasters also expect only a gradual recovery in consumer spending. In part, this is because the drop in home prices and the fall in the stock market during the height of the crisis reduced household wealth. It’s also because the availability of household credit has tightened. In addition, the unemployment rate currently is at 9.7 percent. For states in the Federal Reserve’s Seventh District, unemployment was 11 percent in December. With such a depressed labor market, workers are seeing little growth in wages and salaries. So, with credit tight and households needing to repair their balance sheets, consumer spending will gain momentum only as people get back to work.
Employment is often the last piece of the puzzle to fall into place during a recovery. This will certainly be true this time. Many businesses slashed payrolls during the recession, and going forward, many are hoping to keep staffing levels lean. Indeed, even though output was increasing, employment still fell substantially during the second half of 2009. Toward the end of the year, however, the pace of job loss moderated significantly. Some of the businesses that cut their payrolls most deeply during the recession have begun to rehire workers. Others have accommodated recent increases in demand by hiring temporary workers. This is just the first stage of the recovery process. Most employers are very cautious about hiring at this time, given the uncertainty over the pace of the recovery. But I think that many businesses already are finding they can take lean production only so far. These firms should be ready to expand permanent hiring once they see clearer signs of sustained increases in demand.
The picture with regard to financing conditions is complex to say the least. On the plus side, more and more financial markets are functioning well without the need for ongoing government support. As a result, large firms are able to borrow at reasonable spreads, both short term in commercial paper markets and long term in corporate bond markets. On the down side, the availability of bank credit remains a significant headwind for many small- and medium-sized companies. Some of the decline in bank lending that we saw last year reflects weak demand for loans by businesses wary of taking on new debt burdens in an uncertain economic environment. But at least some of the reduced lending arises from banks’ tighter lending standards. These tighter standards, in turn, appear to reflect banks’ concern over their capital levels and also the credit quality of borrows. More generally, credit flows are being reduced because both borrowers and lenders are still dealing with losses from the recession, especially the busts in residential and commercial real estate. I expect banking conditions to improve, but this is likely to take some time.
Looking ahead, I anticipate that restrictive bank credit, along with business and household caution, will continue to restrain the recovery’s strength. Nevertheless I expect these dampening influences to abate as we move through 2010. We at the Chicago Fed expect GDP growth to average 3 to 3-1/2 percent in 2010. Such growth is only slightly above our estimate of the economy’s potential growth rate, which means unemployment will likely decline only modestly in 2010.
Of course, the recovery could exceed these expectations. The growth we’re expecting is modest for a recovery following a deep recession, which is typically followed by a sharp increase in economic activity. For example, GDP growth in the year and a half following the recession of 1981 and 1982 averaged about 8 percent. While that’s not the case now, some of the recent data have been better than expected. Increases in confidence could turn into higher spending sooner than we think. And an important longer-term factor is that productivity growth has remained strong. Technology continues to advance, and firms continue to create new products and find new ways to produce more efficiently. Such productivity gains will result in higher incomes and improving standards of living over the longer term.
Well, that was a long answer to a short question about the recovery. The second question I’m often asked comes in two versions. The first version is: Isn’t inflation about to go through the roof? The second version is: Isn’t inflation about to fall further—aren’t we looking at deflation? The answer is no in both cases: I think inflation will remain relatively stable. But the fact that I get these completely different questions highlights the degree of uncertainty currently underlying the inflation outlook. Surveys of consumer inflation expectations, professional forecasters’ projections, and the implied inflation forecasts from the market for Treasury Inflation-Protected Securities all see inflation running close to current rates over the medium term. But these stable inflation expectations balance out some important crosscurrents. I’m reminded of the old joke that says if you put two economists in a room you’ll get at least three opinions. Well, that’s especially true now.
The current low rates of resource utilization strongly point to lower inflation. The 9.7 percent unemployment rate and the still very low rates of manufacturing capacity utilization are factors that reduce cost pressures and make firms less able to push through price increases. In fact, these factors have significantly contributed to a recent decline in inflation. The Fed’s preferred measure of core inflation—the deflator for Personal Consumption Expenditures, or PCE, excluding food and energy—has fallen from 2.7 percent in August 2008 to 1.4 percent in January 2010. That is a large decline for a relatively slow moving data series.
The people who press me on higher inflation point to the Fed’s expanded balance sheet and the associated large increase in what economists call the monetary base. We all know that too much money chasing too few goods will generate inflation. But, currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those reserves, they are not generating spending pressure. Of course, leaving the current highly accommodative monetary policy in place for too long would eventually fuel inflationary pressures.
With core inflation at 1-1/2 percent, we see the opposing forces of resource gaps and accommodative monetary policy as roughly balancing out over the medium term. Resource slack could result in core PCE inflation coming down a bit more in 2010 and 2011. As resource slack abates in a recovering economy, I expect inflation to move up to about 1-3/4 percent in 2012.
To achieve this outlook, monetary policy cannot be passive. A large challenge facing policymakers over the next couple of years will be judging the appropriate timing and pace for reducing accommodation. On the one hand, removing too much accommodation prematurely could choke off the recovery. On the other hand, as I noted, if the Fed leaves the current level of accommodation in place too long, inflationary pressures will eventually build. The Fed is preparing for these decisions by carefully monitoring business activity and remaining alert for signs of incipient inflation. In addition, the FOMC is making sure that it has the technical tools it will need when it decides to reduce monetary accommodation. Overall, I am confident that monetary policy will bring and keep inflation near my guideline of 2 percent over the medium term.
Needless to say, the crisis and recession have kept us busy. But we have also devoted a good deal of energy to reflecting on events of the past several years. This is, in large part, because of the importance of the last question I have been asked recently: What have you at the Federal Reserve learned about how to guard against future financial crises again creating such a major recession? It is not always worded so nicely! There are, of course, a number of lessons. I’d like to touch on a couple of them now.
One lesson is that responding effectively during times of crisis may require innovative and targeted policy tools. As the crisis arose, we first used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount window. However, we lowered the funds rate to zero—as far as it can go—and still were facing frozen credit markets and severely deteriorating macroeconomic conditions. We thus turned to nontraditional tools to clear up the choke points. These included providing liquidity directly to nonbank financial institutions, and supporting a number of short-term credit markets. We also purchased additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of government-sponsored enterprises. These purchases further reduced long-term interest rates.
These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction. Of course, in the future it would be best to reduce the chances of facing financial crises in the first place by better protecting the economy from systemic financial risks. Another important lesson is that to be most effective, financial market supervision needs to be based on prospective economic conditions and applied at the same time across the range of institutions. This is an essential aspect of an approach known as horizontal macroprudential regulation. Such an approach was taken during the Supervisory Capital Assessment Program (what we called the SCAP). In the popular press this was better known as the bank stress tests. This was an important effort undertaken in the spring of 2009 that went a long way toward stabilizing and restoring trust in the banking system.
During SCAP, the Fed and other regulators worked with the 19 largest bank holding companies to evaluate the banks’ capital adequacy under two macroeconomic scenarios. One was a baseline that embodied the expectations of most professional forecasters at the time. The other was a more adverse scenario, which ended up being closer to how the economy actually performed. As part of the exercise, banks’ assets were grouped into several buckets—categories such as First-Lien Mortgages, Junior Mortgages, Commercial Real Estate loans, etc. Both the banks and the SCAP staff of more than 150 examiners, economists, accountants, and other bank supervision specialists were asked to evaluate how these assets would perform under the two scenarios. Comparing the different assessments and working through them led to a much better understanding of the strengths and weaknesses of the leading bank holding companies.
In the end, the results indicated which institutions would need additional capital to cover their losses and maintain good capital ratios in the worse-than-expected macroeconomic environment. With this information in hand, the Fed, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) compelled institutions that fell short of this common benchmark to increase their capital. And they did. The information made public after the SCAP helped private investors make more confident valuations of the banks. Nearly all banks then were able to raise new capital on public equity markets without drawing on additional government funds.
I see a number of benefits to making similar macroprudential stress tests routine. Such horizontal cross-bank reviews of balance sheets and risk exposures can identify potential systemic risks that might escape an institution-by-institution analysis. Furthermore, they provide a ready way for supervisory reviews and actions to respond to the latest information on macroeconomic developments. In addition, going forward, we might consider dynamic capital standards that would require banks to build their capital base during periods of strong economic growth and high bank profitability, and let banks draw down their capital cushions during downturns when profits and capital tend to be more scarce.
Such proactive bank supervision requires collaboration between economists and regulators. The Federal Reserve has many well-trained and experienced economists gathering intelligence and analyzing incoming data to prepare the Federal Reserve System’s Governors and Bank presidents for their monetary policy decisions. I believe that the same macroeconomic insights can help promote financial stability by substantially improving regulators’ ability to identify and assess risks that are relevant to a range of financial institutions. This was demonstrated during the SCAP and this approach will be applied to other supervisory efforts.
At the same time, we have well-trained and experienced bank examiners who can offer sound judgments on the creditworthiness of financial institutions’ balance sheets. Such supervisory information can and does make a valuable contribution to monetary policy analysis. For a number of years, we at the Chicago Fed have included information on banks’ financial condition and lending activity from our staff in Supervision and Regulation in our regular preparation for monetary policy meetings. Since a recovery in bank lending capacity and inclination will be an important indicator of self-sustaining momentum in the recovery and of the appropriate time to adjust monetary policy, this information is crucial now more than ever.
Just a minute ago, I used the term macroprudential regulation. This is part of a shift in our philosophy spurred by the crisis. Since Congress created the Federal Reserve System in 1913, our approach to preventing financial crises has relied on the microprudential supervision and regulation of individual banks. In theory, ensuring sound lending standards and adequate capitalization on a bank-by-bank basis would reassure depositors that their money was safe and prevent panics. Such panics were all too common in the late nineteenth and early twentieth centuries, and were important factors leading to the formation of the Fed. If a problem bank slipped through this regulatory safety net, we could use our powers as the lender of last resort to prevent its weakness from contaminating a broader range of institutions. And, if there were macroeconomic consequences, then monetary policy could be eased to mitigate the overall effects on the economy.
Of course, as Chairman Bernanke and other experts on the Great Depression have noted, the 1930s Fed failed to use these tools well enough. But from then until the current episode, this approach appeared to suffice, even as our financial system became more dependent on nonbank financial intermediaries, such as broker–dealers, hedge funds, and other institutions beyond the regulatory reach of the Fed and the other banking regulators. Nevertheless, the scale and scope of the past few years’ events have exposed the weaknesses of a bank-by-bank regulatory approach to guarding against the macroeconomic risks stemming from financial instability.
One highly visible characteristic of our recent financial instability was the bubble that arose in the housing market and its subsequent collapse. Now, in the aftermath of that bubble’s collapse, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may have emerged. This is often described as an imperative to “lean against potential bubbles,” meaning that the central bank should act to lower asset prices that, according to some benchmark, seem unusually high. Now not all financial crises arise from bubbles; the implosion of Long-Term Capital Management (LTCM) following the Russian bond default is a case in point, so a policy of leaning against bubbles is at best incomplete. Moreover, there are good reasons to think that using one of the traditional monetary policy tools—namely, adjusting the short-term policy interest rate—to lean against a potential bubble could be ineffective and maybe even counterproductive. One argument is that interest rate policy is too blunt of a tool to effectively prick bubbles—it cannot be targeted precisely, and thus will affect other financial and macroeconomic variables beyond just the set of asset prices in question. A second argument is that the typical changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices. I continue to find these two arguments quite persuasive, which is why at this point I think that well-structured regulatory policy provides the most promise in protecting the economy from financial crisis.
I’d like to conclude at this point, but I hope you’ll recall that the answers to our three questions about recovery, inflation, and the financial crisis were yes, no, and we’ve learned a lot. Giving shorter answers to these questions is certainly easy and often necessary, but always frustrating. Today, more than at any time in recent memory, people want to know about the Federal Reserve, the things we do and think about, and how we put the pieces together to create a picture of the current economy. We’re doing our best to satisfy that demand by providing as much information as we can to business people and bankers, members of Congress, the media, and, most important, consumers and the public.
Thank you for the opportunity to be with you today. I look forward to your questions.
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Remarks by Charles L. Evans
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