Bernanke Speech: Economic Outlook and Recent Monetary Policy Actions

Chairman Ben S. Bernanke

Economic Outlook and Recent Monetary Policy Actions

Before the Joint Economic Committee, U.S. Congress, Washington, D.C.

October 4, 2011

Chairman Casey, Vice Chairman Brady, and other members of the Committee, I appreciate this opportunity to discuss the economic outlook and recent monetary policy actions.

It has been three years since the beginning of the most intense phase of the financial crisis in the late summer and fall of 2008, and more than two years since the economic recovery began in June 2009. There have been some positive developments: The functioning of financial markets and the banking system in the United States has improved significantly. Manufacturing production in the United States has risen nearly 15 percent since its trough, driven substantially by growth in exports; indeed, the U.S. trade deficit has been notably lower recently than it was before the crisis, reflecting in part the improved competitiveness of U.S. goods and services. Business investment in equipment and software has continued to expand, and productivity gains in some industries have been impressive. Nevertheless, it is clear that, overall, the recovery from the crisis has been much less robust than we had hoped. Recent revisions of government economic data show the recession as having been even deeper, and the recovery weaker, than previously estimated; indeed, by the second quarter of this year--the latest quarter for which official estimates are available--aggregate output in the United States still had not returned to the level that it had attained before the crisis. Slow economic growth has in turn led to slow rates of increase in jobs and household incomes.

The pattern of sluggish growth was particularly evident in the first half of this year, with real gross domestic product (GDP) estimated to have increased at an average annual rate of less than 1 percent. Some of this weakness can be attributed to temporary factors. Notably, earlier this year, political unrest in the Middle East and North Africa, strong growth in emerging market economies, and other developments contributed to significant increases in the prices of oil and other commodities, which damped consumer purchasing power and spending; and the disaster in Japan disrupted global supply chains and production, particularly in the automobile industry. With commodity prices having come off their highs and manufacturers' problems with supply chains well along toward resolution, growth in the second half of the year seems likely to be more rapid than in the first half.

However, the incoming data suggest that other, more persistent factors also continue to restrain the pace of recovery. Consequently, the Federal Open Market Committee (FOMC) now expects a somewhat slower pace of economic growth over coming quarters than it did at the time of the June meeting, when Committee participants most recently submitted economic forecasts.

Consumer behavior has both reflected and contributed to the slow pace of recovery. Households have been very cautious in their spending decisions, as declines in house prices and in the values of financial assets have reduced household wealth, and many families continue to struggle with high debt burdens or reduced access to credit. Probably the most significant factor depressing consumer confidence, however, has been the poor performance of the job market. Over the summer, private payrolls rose by only about 100,000 jobs per month on average--half of the rate posted earlier in the year.¹ Meanwhile, state and local governments have continued to shed jobs, as they have been doing for more than two years. With these weak gains in employment, the unemployment rate has held close to 9 percent since early this year. Moreover, recent indicators, including new claims for unemployment insurance and surveys of hiring plans, point to the likelihood of more sluggish job growth in the period ahead.

Other sectors of the economy are also contributing to the slower-than-expected rate of expansion. The housing sector has been a significant driver of recovery from most recessions in the United States since World War II. This time, however, a number of factors--including the overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and the large number of "underwater" mortgages (on which homeowners owe more than their homes are worth)--have left the rate of new home construction at only about one-third of its average level in recent decades.

In the financial sphere, as I noted, banking and financial conditions in the United States have improved significantly since the depths of the crisis. Nonetheless, financial stresses persist. Credit remains tight for many households, small businesses, and residential and commercial builders, in part because weaker balance sheets and income prospects have increased the perceived credit risk of many potential borrowers. We have also recently seen bouts of elevated volatility and risk aversion in financial markets, partly in reaction to fiscal concerns both here and abroad. Domestically, the controversy during the summer regarding the raising of the federal debt ceiling and the downgrade of the U.S. long-term credit rating by one of the major rating agencies contributed to the financial turbulence that occurred around that time. Outside the United States, concerns about sovereign debt in Greece and other euro-zone countries, as well as about the sovereign debt exposures of the European banking system, have been a significant source of stress in global financial markets. European leaders are strongly committed to addressing these issues, but the need to obtain agreement among a large number of countries to put in place necessary backstops and to address the sources of the fiscal problems has slowed the process of finding solutions. It is difficult to judge how much these financial strains have affected U.S. economic activity thus far, but there seems little doubt that they have hurt household and business confidence, and that they pose ongoing risks to growth.

Another factor likely to weigh on the U.S. recovery is the increasing drag being exerted by the government sector. Notably, state and local governments continue to tighten their belts by cutting spending and employment in the face of ongoing budgetary pressures, while the future course of federal fiscal policies remains quite uncertain.

To be sure, fiscal policymakers face a complex situation. I would submit that, in setting tax and spending policies for now and the future, policymakers should consider at least four key objectives. One crucial objective is to achieve long-run fiscal sustainability. The federal budget is clearly not on a sustainable path at present. The Joint Select Committee on Deficit Reduction, formed as part of the Budget Control Act, is charged with achieving $1.5 trillion in additional deficit reduction over the next 10 years on top of the spending caps enacted this summer. Accomplishing that goal would be a substantial step; however, more will be needed to achieve fiscal sustainability.

A second important objective is to avoid fiscal actions that could impede the ongoing economic recovery. These first two objectives are certainly not incompatible, as putting in place a credible plan for reducing future deficits over the longer term does not preclude attending to the implications of fiscal choices for the recovery in the near term. Third, fiscal policy should aim to promote long-term growth and economic opportunity. As a nation, we need to think carefully about how federal spending priorities and the design of the tax code affect the productivity and vitality of our economy in the longer term. Fourth, there is evident need to improve the process for making long-term budget decisions, to create greater predictability and clarity, while avoiding disruptions to the financial markets and the economy. In sum, the nation faces difficult and fundamental fiscal choices, which cannot be safely or responsibly postponed.

Returning to the discussion of the economic outlook, let me turn now to the prospects for inflation. Prices of many commodities, notably oil, increased sharply earlier this year, as I noted, leading to higher retail gasoline and food prices. In addition, producers of other goods and services were able to pass through some of their higher input costs to their customers. Separately, the global supply disruptions associated with the disaster in Japan put upward pressure on prices of motor vehicles. As a result of these influences, inflation picked up during the first half of this year; over that period, the price index for personal consumption expenditures rose at an annual rate of about 3-1/2 percent, compared with an average of less than 1-1/2 percent over the preceding two years.

As the FOMC anticipated, however, inflation has begun to moderate as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs, and the step-up in automobile production has started to reduce pressures on the prices of cars and light trucks. Importantly, the higher rate of inflation experienced so far this year does not appear to have become ingrained in the economy. Longer-term inflation expectations have remained stable according to surveys of households and economic forecasters, and the five-year-forward measure of inflation compensation derived from yields on nominal and inflation-protected Treasury securities suggests that inflation expectations among investors may have moved lower recently. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack in U.S. labor and product markets should continue to restrain inflationary pressures.

In view of the deterioration in the economic outlook over the summer and the subdued inflation picture over the medium run, the FOMC has taken several steps recently to provide additional policy accommodation. At the August meeting, the Committee provided greater clarity about its outlook for the level of short-term interest rates by noting that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. And at our meeting in September, the Committee announced that it intends to increase the average maturity of the securities in the Federal Reserve's portfolio. Specifically, it intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less, leaving the size of our balance sheet approximately unchanged. This maturity extension program should put downward pressure on longer-term interest rates and help make broader financial conditions more supportive of economic growth than they would otherwise have been.

The Committee also announced in September that it will begin reinvesting principal payments on its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities rather than in longer-term Treasury securities. By helping to support mortgage markets, this action too should contribute to a stronger economic recovery. The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

 

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1. The figure of 100,000 private jobs per month adjusts for the effects of the two-week strike by communications workers at Verizon, which held down measured payrolls in August. Return to text

Business Monitor International Report Highlights the Risks of a Double-dip Recession

Press Release
LONDON, August 22, 2011 /PRNewswire/ --

Business Monitor International (BMI) has released its latest special report, "Market Meltdown: Global Economy On The Edge" evaluating the major risks to the world economy arising from the recent slump in global stock prices and rise in vulnerable government bond yields.

With the Eurozone affected by the on-going sovereign debt crises, the US faced with debt concerns after losing its AAA credit rating, and Japan still suffering from the consequences of March's earthquake, the global economy is threatened by a risk of another recession.

On August 5 2011, Standard & Poor's (S&P) lowered its long-term sovereign credit rating for the United States to AA+ from AAA, while maintaining a negative outlook. Prior to S&P's announcement, poor Q211 GDP data and revisions to the GDP series going back to 2010 had a significant impact on the US economic outlook. The report focuses on the recent market developments, outlines revisions to BMI's US growth forecasts and provides insight into the US ratings downgrade. Furthermore it examines a possibility of a double-dip recession in the US.

BMI also analyses the implications of the Eurozone debt crisis for European politics, financial market strategies and the European banking sector. Considering market scepticism over the sustainability of the Eurozone, the current crises represent the biggest test for European institutions since the collapse of Yugoslavia in the 1990s, and one with far graver economic implications.

Moreover, "Market Meltdown: Global Economy On The Edge" assesses the contagion risks of the eurozone and US crises for Asia; from banking sector exposure, the stress on states with weak fiscal positions, and the impact on China's economy and the rest of the region should global trade flows be disrupted by a weakening US dollar, or lower import demand from the US and Europe.

BMI's unique combination of global macro-economic forecasting, industry knowledge and long track-record of emerging markets forecasting enables global investors, strategists and decision-makers across the corporate spectrum to identify key market opportunities and avoid market risks wherever they operate.

About Business Monitor International:

Business Monitor International (BMI) established in 1984 with headquarters in London is recognised as a leading independent source for analysis and forecasts on Country Risk and Industry, spanning 175 countries. BMI provides research to multinational corporations, banks, funds, research centres and governments in 140 countries around the world, including more than 400 of the Fortune Global 500 companies.

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Fannie Mae's Economic & Mortgage Market Analysis Group Forecasts Economic Growth To Average 3.1 Percent For 2011, A Downgrade From 3.5 Percent

Press Release

The Economy Hits an Air Pocket According to Fannie Mae's Economic & Mortgage Market Analysis Group

Global Events Affecting Economic Outlook

No Improvement for Outlook in Housing Sector

WASHINGTON, DC — Global events during March, including ongoing political turmoil in the Middle East and North Africa, the surge in oil prices, and supply disruptions from the tragedy in Japan, have dampened U.S. economic growth in the first half of 2011, according to the April 2011 Economic Outlook released today by Fannie Mae's (FNMA/OTC) Economics & Mortgage Market Analysis Group. The slowdown in growth is expected to be temporary, however, with a modest acceleration in economic growth projected for the second half of the year. The group forecasts economic growth to average 3.1 percent for 2011, a downgrade from 3.5 percent projected in the prior forecast.


(See the full economic forecast from Fannie Mae here.)

Home sales were weak in the first part of 2011, with distressed sales (foreclosure and short sales) continuing to account for more than a third of total existing home sales. In turn, a rising share of distressed sales and the winding down of various programs to support the housing market have caused home price measures to decline.

“Home price expectations have deteriorated during the past several months, which could cause some potential homebuyers to remain on the sidelines — and further sharp cutbacks in housing demand would pose a risk to the fragile housing recovery,” said Fannie Mae Chief Economist Doug Duncan. “We expect a little more decline in house prices at the national level than we had thought previously, but expect prices to begin stabilizing later this year.”

On the upside, recent employment reports have been very strong, with more than 230,000 private sector payroll jobs added in each of the last two months. “We anticipate there will be continued reasonably good news in employment through the rest of the year,” said Duncan. “If that continues, we expect housing to move in a similar positive direction — hopefully by the second half of 2011.”

For an audio synopsis of the April 2011 Economic Outlook, listen to the podcast on the Economics & Mortgage Market Analysis site at www.fanniemae.com. Visit the site to read the full April 2011 Economic Outlook, including the Economic Developments Commentary, Economic Forecast, and Housing Forecast.

Also available via link from the Economic Developments Commentary is the Multifamily Market Commentary by Kim Betancourt, Director, Multifamily Economics and Market Research. The Commentary provides information on current multifamily market conditions with a focus on multifamily mortgage debt outstanding in 2010.
   
Opinions, analyses, estimates, forecasts, and other views of Fannie Mae's Economics & Mortgage Market Analysis (EMMA) group included in these materials should not be construed as indicating Fannie Mae's business prospects or expected results, are based on a number of assumptions, and are subject to change without notice. How this information affects Fannie Mae will depend on many factors. Although the EMMA group bases its opinions, analyses, estimates, forecasts, and other views on information it considers reliable, it does not guarantee that the information provided in these materials is accurate, current, or suitable for any particular purpose. Changes in the assumptions or the information underlying these views could produce materially different results. The analyses, opinions, estimates, forecasts, and other views published by the EMMA group represent the views of that group as of the date indicated and do not necessarily represent the views of Fannie Mae or its management.

Fannie Mae exists to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market. Fannie Mae has a federal charter and operates in America's secondary mortgage market to enhance the liquidity of the mortgage market by providing funds to mortgage bankers and other lenders so that they may lend to home buyers. Our job is to help those who house America.

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Fed Chairman Ben S. Bernanke Semiannual Monetary Policy Report to the Congress

Chairman Ben S. Bernanke
Semiannual Monetary Policy Report to the Congress
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.
March 1, 2011

Chairman Johnson, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. I will begin with a discussion of economic conditions and the outlook before turning to monetary policy.

The Economic Outlook
Following the stabilization of economic activity in mid-2009, the U.S. economy is now in its seventh quarter of growth; last quarter, for the first time in this expansion, our nation's real gross domestic product (GDP) matched its pre-crisis peak. Nevertheless, job growth remains relatively weak and the unemployment rate is still high.

In its early stages, the economic recovery was largely attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and a strong boost to production from businesses rebuilding their depleted inventories. Economic growth slowed significantly in the spring and early summer of 2010, as the impetus from inventory building and fiscal stimulus diminished and as Europe's debt problems roiled global financial markets. More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending has grown at a solid pace since last fall, and business investment in new equipment and software has continued to expand. Stronger demand, both domestic and foreign, has supported steady gains in U.S. manufacturing output.

The combination of rising household and business confidence, accommodative monetary policy, and improving credit conditions seems likely to lead to a somewhat more rapid pace of economic recovery in 2011 than we saw last year. The most recent economic projections by Federal Reserve Board members and Reserve Bank presidents, prepared in conjunction with the Federal Open Market Committee (FOMC) meeting in late January, are for real GDP to increase 3-1/2 to 4 percent in 2011, about one-half percentage point higher than our projections made in November.1 Private forecasters' projections for 2011 are broadly consistent with those of the FOMC participants and have also moved up in recent months.2

While indicators of spending and production have been encouraging on balance, the job market has improved only slowly. Following the loss of about 8-3/4 million jobs from early 2008 through 2009, private-sector employment expanded by only a little more than 1 million during 2010, a gain barely sufficient to accommodate the inflow of recent graduates and other entrants to the labor force. We do see some grounds for optimism about the job market over the next few quarters, including notable declines in the unemployment rate in December and January, a drop in new claims for unemployment insurance, and an improvement in firms' hiring plans. Even so, if the rate of economic growth remains moderate, as projected, it could be several years before the unemployment rate has returned to a more normal level. Indeed, FOMC participants generally see the unemployment rate still in the range of 7-1/2 to 8 percent at the end of 2012. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.

Likewise, the housing sector remains exceptionally weak. The overhang of vacant and foreclosed houses is still weighing heavily on prices of new and existing homes, and sales and construction of new single-family homes remain depressed. Although mortgage rates are low and house prices have reached more affordable levels, many potential homebuyers are still finding mortgages difficult to obtain and remain concerned about possible further declines in home values.

Inflation has declined, on balance, since the onset of the financial crisis, reflecting high levels of resource slack and stable longer-term inflation expectations. Indeed, over the 12 months ending in January, prices for all of the goods and services consumed by households (as measured by the price index for personal consumption expenditures (PCE)) increased by only 1.2 percent, down from 2.5 percent in the year-earlier period. Wage growth has slowed as well, with average hourly earnings increasing only 1.9 percent over the year ending in January. In combination with productivity increases, slow wage growth has implied very tight restraint on labor costs per unit of output.

FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.3 Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts. Surveys of households suggest that the public's longer-term inflation expectations also remain stable.

Although overall inflation is low, since summer we have seen significant increases in some highly visible prices, including those of gasoline and other commodities. Notably, in the past few weeks, concerns about unrest in the Middle East and North Africa and the possible effects on global oil supplies have led oil and gasoline prices to rise further. More broadly, the increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases. Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months.

The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations. Currently, the cost pressures from higher commodity prices are also being offset by the stability in unit labor costs. Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation--an outlook consistent with the projections of both FOMC participants and most private forecasters. That said, sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability, particularly if they were to cause inflation expectations to become less well anchored. We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability.

Monetary Policy
As I noted earlier, the pace of recovery slowed last spring--to a rate that, if sustained, would have been insufficient to make meaningful progress against unemployment. With job creation stalling, concerns about the sustainability of the recovery increased. At the same time, inflation--already at very low levels--continued to drift downward, and market-based measures of inflation compensation moved lower as investors appeared to become more concerned about the possibility of deflation, or falling prices.4

Under such conditions, the Federal Reserve would normally ease monetary policy by reducing the target for its short-term policy interest rate, the federal funds rate. However, the target range for the federal funds rate has been near zero since December 2008, and the Federal Reserve has indicated that economic conditions are likely to warrant an exceptionally low target rate for an extended period. Consequently, another means of providing monetary accommodation has been necessary since that time. In particular, over the past two years the Federal Reserve has eased monetary conditions by purchasing longer-term Treasury securities, agency debt, and agency mortgage-backed securities (MBS) on the open market. The largest program of purchases, which lasted from December 2008 through March 2010, appears to have contributed to an improvement in financial conditions and a strengthening of the recovery. Notably, the substantial expansion of the program announced in March 2009 was followed by financial and economic stabilization and a significant pickup in the growth of economic activity in the second half of that year.

 In August 2010, in response to the already-mentioned concerns about the sustainability of the recovery and the continuing declines in inflation to very low levels, the FOMC authorized a policy of reinvesting principal payments on our holdings of agency debt and agency MBS into longer-term Treasury securities. By reinvesting agency securities, rather than allowing them to continue to run off as our previous policy had dictated, the FOMC ensured that a high level of monetary accommodation would be maintained. Over subsequent weeks, Federal Reserve officials noted in public remarks that we were considering providing additional monetary accommodation through further asset purchases. In November, the Committee announced that it intended to purchase an additional $600 billion in longer-term Treasury securities by the middle of this year.

Large-scale purchases of longer-term securities are a less familiar means of providing monetary policy stimulus than reducing the federal funds rate, but the two approaches affect the economy in similar ways. Conventional monetary policy easing works by lowering market expectations for the future path of short-term interest rates, which, in turn, reduces the current level of longer-term interest rates and contributes to both lower borrowing costs and higher asset prices. This easing in financial conditions bolsters household and business spending and thus increases economic activity. By comparison, the Federal Reserve's purchases of longer-term securities, by lowering term premiums, put downward pressure directly on longer-term interest rates. By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy.

A wide range of market indicators supports the view that the Federal Reserve's recent actions have been effective. For example, since August, when we announced our policy of reinvesting principal payments on agency debt and agency MBS and indicated that we were considering more securities purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen to historically more normal levels. Yields on 5- to 10-year nominal Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases. All of these developments are what one would expect to see when monetary policy becomes more accommodative, whether through conventional or less conventional means. Interestingly, these market responses are almost identical to those that occurred during the earlier episode of policy easing, notably in the months following our March 2009 announcement. In addition, as I already noted, most forecasters see the economic outlook as having improved since our actions in August; downside risks to the recovery have receded, and the risk of deflation has become negligible. Of course, it is too early to make any firm judgment about how much of the recent improvement in the outlook can be attributed to monetary policy, but these developments are consistent with it having had a beneficial effect.

My colleagues and I continue to regularly review the asset purchase program in light of incoming information, and we will adjust it as needed to promote the achievement of our mandate from the Congress of maximum employment and stable prices. We also continue to plan for the eventual exit from unusually accommodative monetary policies and the normalization of the Federal Reserve's balance sheet. We have all the tools we need to achieve a smooth and effective exit at the appropriate time. Currently, because the Federal Reserve's asset purchases are settled through the banking system, depository institutions hold a very high level of reserve balances with the Federal Reserve. Even if bank reserves remain high, however, our ability to pay interest on reserve balances will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required. Moreover, we have developed and tested additional tools that will allow us to drain or immobilize bank reserves to the extent needed to tighten the relationship between the interest rate paid on reserves and other short-term interest rates.5 If necessary, the Federal Reserve can also drain reserves by ceasing the reinvestment of principal payments on the securities it holds or by selling some of those securities in the open market. The FOMC remains unwaveringly committed to price stability and, in particular, to achieving a rate of inflation in the medium term that is consistent with the Federal Reserve's mandate.

Federal Reserve Transparency
The Congress established the Federal Reserve, set its monetary policy objectives, and provided it with operational independence to pursue those objectives. The Federal Reserve's operational independence is critical, as it allows the FOMC to make monetary policy decisions based solely on the longer-term needs of the economy, not in response to short-term political pressures. Considerable evidence supports the view that countries with independent central banks enjoy better economic performance over time.6

However, in our democratic society, the Federal Reserve's independence brings with it the obligation to be accountable and transparent. The Congress and the public must have all the information needed to understand our decisions, to be assured of the integrity of our operations, and to be confident that our actions are consistent with the mandate given to us by the Congress.

On matters related to the conduct of monetary policy, the Federal Reserve is one of the most transparent central banks in the world, making available extensive records and materials to explain its policy decisions. For example, beyond the semiannual Monetary Policy Report I am presenting today, the FOMC provides a post-meeting statement, a detailed set of minutes three weeks after each policy meeting, quarterly economic projections together with an accompanying narrative, and, with a five-year lag, a transcript of each meeting and its supporting materials. In addition, FOMC participants often discuss the economy and monetary policy in public forums, and Board members testify frequently before the Congress.

In recent years the Federal Reserve has also substantially increased the information it provides about its operations and its balance sheet. In particular, for some time the Federal Reserve has been voluntarily providing extensive financial and operational information regarding the special credit and liquidity facilities put in place during the financial crisis, including full descriptions of the terms and conditions of each facility; monthly reports on, among other things, the types of collateral posted and the mix of participants using each facility; weekly updates about borrowings and repayments at each facility; and many other details.7 Further, on December 1, as provided by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Federal Reserve Board posted on its public website the details of more than 21,000 individual credit and other transactions conducted to stabilize markets and support the economic recovery during the crisis. This transaction-level information demonstrated the breadth of these operations and the care that was taken to protect the interests of the taxpayer; indeed, despite the scope of these actions, the Federal Reserve has incurred no credit losses to date on any of the programs and expects no credit losses in any of the few programs that still have loans outstanding. Moreover, we are fully confident that independent assessments of these programs will show that they were highly effective in helping to stabilize financial markets, thus strengthening the economy. Overall, the operational effectiveness of the programs was recently supported as part of a comprehensive review of six lending facilities by the Board's independent Office of Inspector General.8 In addition, we have been working closely with the Government Accountability Office, the Office of the Special Inspector General for the Troubled Asset Relief Program, the Congressional Oversight Panel, the Congress, and private-sector auditors on reviews of these facilities as well as a range of matters relating to the Federal Reserve's operations and governance. We will continue to seek ways of enhancing our transparency without compromising our ability to conduct policy in the public interest.

Thank you. I would be pleased to take your questions.




1. Forecast ranges here and below refer to the central tendencies of the projections of FOMC participants, as presented in the "Summary of Economic Projections" released with the minutes of the January FOMC meeting. Return to text

2. For example, both the Survey of Professional Forecasters (see the first quarter 2011 survey Leaving the Board released by the Federal Reserve Bank of Philadelphia on February 11) and the Blue Chip forecasting panel (see the February 10, 2010, issue of Blue Chip Economic Indicators (New York: Aspen Publishers)) now project real GDP growth of about 3-1/2 percent from the fourth quarter of 2010 to the fourth quarter of 2011, about one-half percentage point higher than the corresponding projections made in August. Looking further ahead, most FOMC participants project that economic growth will pick up a bit more in 2012 and 2013, whereas private forecasters tend to see the expansion proceeding fairly steadily over the next few years. (Note: Blue Chip Economic Indicators and Blue Chip Financial Forecasts are publications owned by Aspen Publishers. Copyright © 2009 by Aspen Publishers, Inc. All rights reserved; www.aspenpublishers.com.) Return to text

3. The Survey of Professional Forecasters projects PCE inflation to run at about 1-1/2 percent in 2011 and to subsequently rise gradually to nearly 2 percent by 2013. The corresponding projections from the Survey of Professional Forecasters for Consumer Price Index (CPI) inflation are about 1-3/4 percent this year and about 2 percent next year and in 2013. Blue Chip forecasts for CPI inflation stand at about 2 percent for both 2011 and 2012. Return to text

4. For example, deflation probabilities inferred from prices of certain inflation-indexed bonds increased during this period. Return to text

5. These tools include the ability to execute term reverse repurchase agreements with the primary dealers and other counterparties, which drains reserves from the banking system; and the issuance of term deposits to depository institutions, which immobilizes bank reserves for the period of the deposit. Return to text

6. See, for example, Alberto Alesina and Lawrence H. Summers (1993), "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Leaving the Board Journal of Money, Credit and Banking, vol. 25 (May), pp. 151-62; or, more recently, Christopher Crowe and Ellen E. Meade (2008), "Central Bank Independence and Transparency: Evolution and Effectiveness," Leaving the Board European Journal of Political Economy, vol. 24 (December), pp. 763-77. See Ben S. Bernanke (2010), "Central Bank Independence, Transparency, and Accountability," at the Institute for Monetary and Economic Studies International Conference, Bank of Japan, Tokyo (May 25), for further discussion and references. Return to text

7. See the reports available on the Board's webpage, "Credit and Liquidity Programs and the Balance Sheet." Return to text

8. See Board of Governors of the Federal Reserve System, Office of Inspector General (2010), The Federal Reserve's Section 13(3) Lending Facilities to Support Overall Market Liquidity: Function, Status, and Risk Management (1.5 MB PDF) (Washington: Board of Governors OIG, November).

US Fiscal Policy and the Global Outlook, Speech by John Lipsky, First Deputy Managing Director, IMF

US Fiscal Policy and the Global Outlook
Speech by John Lipsky, First Deputy Managing Director, International Monetary Fund
At the American Economic Association Annual Meetings, Roundtable on "The United States in the World Economy"
Denver, January 8, 2011

Good morning. I’m delighted to take part in this Roundtable, and to have the honor to appear with such an eminent, productive and distinguished panel. I’d like to address three topics in my brief remarks today: the outlook for U.S. fiscal policy, its impact on the global economy, and how new mechanisms for international policy cooperation hold out the promise of improving global economic balance and delivering stronger and more stable growth.

U.S. Fiscal Policy

Turning first to U.S. fiscal policy, the slow pace so far of economic recovery and weak job creation—despite the wide margin of excess capacity—argues for maintaining supportive monetary and fiscal policies in the very near term. Indeed, expansionary fiscal policy already played a critical role in averting a deeper U.S. recession. According to IMF analysis, fiscal measures contributed about 2 percentage points to GDP growth in 2009, and another one percentage point last year. At the same time, federal debt held by the public has risen from about 36 percent of GDP in 2007 to about 62 percent of GDP in 2010, while prospective debt dynamics have worsened significantly. In the absence of corrective measures, and taking into account underlying fiscal pressures that predated the crisis, debt could reach about 95 percent of GDP by the end of this decade—a level last reached immediately following World War II. Without policy adjustments, subsequently the debt simply would keep rising. From this perspective, the need for urgent action to secure medium-term fiscal sustainability appears to be self-evident.

Given the sluggishness of the recovery, the recent adoption of a new U.S. fiscal package is understandable. The measures likely will boost growth this year by about half a percentage point. Of course, it also will raise the deficit. Maintaining a supportive fiscal policy stance at this time reflects the reality that with policy interest rates near zero, the effectiveness of monetary policy is uncertain. Having said this, the Fed’s latest quantitative easing program—that likely will have only a modest impact on growth—appears nonetheless to have reduced perceptions of downside risks, by reinforcing the Fed’s commitment to preventing an ongoing decline in already-low long-term inflation expectations and to supporting the recovery. Although causality is difficult to demonstrate convincingly, inflation expectations rose notably last August—as reflected in the yields on Treasury Inflation Protected Securities (or TIPS)—after the Fed signaled the imminent prospect of further unconventional easing.

The new fiscal package includes several measures that are likely to help boost aggregate demand, although the package also includes other measures that may be less likely to do so. The extension in unemployment benefits will put cash directly into the hands of those with a high propensity to spend—although that is not the sole justification for such a move. The extension of temporary tax breaks for low and middle-income households also will have a positive impact on spending, although with the well-known limitations of temporary tax measures. Other measures were not as well targeted, and the package entails a sizable increase in the deficit—by about 1 percent of GDP in both FY2011 and FY2012—compared to the IMF’s previous forecast, that already included the impact of some anticipated measures (like not changing marginal tax rates for low and middle-income households).

Despite the expected positive impact on growth, the new measures also will make it more difficult for the United States to meet the commitment made by G-20 members at last year's Toronto Summit to halve the deficit as a percent of GDP between 2010 and 2013. In this sense, the stakes are being raised on the development of credible plans to attain medium-term fiscal sustainability.

Indeed, the challenges facing U.S. public finances should not be underestimated, given the sluggish recovery and the prospect of significant increases in aging and health-related spending.

Nonetheless, it’s important to note that only about one-fifth of the overall increase in U.S. public debt projected by the IMF through the end of the decade—a little over 10 percentage points of GDP—is accounted for by the discretionary fiscal measures implemented in response to the recent downturn. And of this, the net cost of the financial sector rescue efforts probably will represent less than 1½ percentage points of GDP (including the support provided to Fannie Mae and Freddie Mac). The bulk of the projected debt increase reflects the severity of the recession that lowered output, raised spending and depressed tax revenues. The prospect that the crisis will have lowered potential growth—thereby lowering the future rate of revenue growth, as well as its current level—also could play a role. Of course, to the extent that growth surprises on the upside, the eventual burden of needed fiscal adjustment could be lightened.

In fact, there may be a brief near-term window of opportunity opening for U.S. fiscal policy adjustment that shouldn't be missed. For now, U.S. interest rates remain low by historical standards—in part due to low growth and inflation prospects, but also reflecting a low risk premium on U.S. government debt. As a result, total public debt service payments have not risen relative to GDP, despite the sharp rise in the U.S. debt-to-GDP ratio. Moreover, as the economy gains momentum, automatic stabilizers will help to lower the deficit—at least in the short run. In our view, the United States needs to make the most of this window of opportunity to tackle structural fiscal problems—especially entitlements—before real rates begin to renormalize, and the positive impact of the automatic stabilizers on the deficit recedes, adding to the perceived difficulty of making progress on longer-run fiscal challenges.

The ongoing debate on how best to achieve medium-term fiscal consolidation has received an important boost from the National Commission on Fiscal Responsibility and Reform. In its recent report, the Commission proposed an ambitious consolidation plan, emphasizing the need for broad-based revenue and spending measures. The plan sets very ambitious targets—to stabilize public debt by FY2014 and return it to its pre-crisis level of about 40 percent of GDP by 2035. Under the Commission's proposals, tax expenditures would be scaled back, allowing marginal tax rates to be reduced. Social Security would be put on a sound financial footing through measures such as means-testing benefits and increasing the retirement age. And to contain health care costs, significant medium-term savings would be attained through a reform of cost-sharing rules and of certain public programs, and also by setting limits—beginning in 2020—on the growth of all federal health-related transfer programs. Another widely-cited idea to support fiscal consolidation—although not put forward by the Commission—is to introduce a national consumption tax, such as a value-added tax—or VAT. Such a measure could enhance national savings while raising revenue with limited economic distortions.

The Commission also calls for reforming budgetary processes to help keep deficit reduction on track. These would include caps on discretionary spending through 2020—with the goal of bringing such spending in real terms back to 2008 levels by 2013; and from then onwards limiting its growth to one-half the projected inflation rate. More generally, by enshrining fiscal targets (including the debt-to-GDP ratio) in budget proposals and by enacting concrete legislation relatively soon, private sector expectations could become progressively more optimistic about fiscal policy prospects, helping the sustained effort that will be needed to anchor fiscal credibility.

Fiscal consolidation not only is a challenge for the federal government, but also for state and local governments. State and local debt currently amounts to about 20 percent of GDP, or about a third of the size of the federal debt. However, unfunded state and local pension and retirement health care entitlements pose significant medium-term risks, as they are estimated at anywhere from $1 trillion to $3 trillion, or possibly equal in size to their outstanding debt. In some states and localities, servicing such a debt burden under current constitutional and other legal strictures would require significant cuts in discretionary spending and/or huge tax increases. Although many states and localities already have started facing these issues, for example by scaling back retirement benefits for new employees, much more decisive action will be required over time in order to reduce medium-term solvency risks.

In contrast to the federal government, most state and local governments are mandated to maintain balanced operational budgets. While this arrangement has prevented a greater run-up in debt, it also has mandated cuts in discretionary spending (and other measures like staff furloughs), following a period in which such spending had increased significantly. Emergency federal transfers, covering about a third of the states’ shortfalls in FY2009 and FY2010, have helped to cushion the blow some extent. For now, state and local revenue appears to be recovering, with tax receipts up 5 percent on an annual basis in the third quarter of 2010. However, the expected phase-out of federal emergency transfers, combined with the need to re-build fiscal reserves and create room for rising entitlements, mean that fiscal consolidation at the local level will remain an ongoing and urgent challenge for some time to come.

Implications for the global economy

With the United States still accounting for a quarter of the global economy, a strengthening of the U.S. recovery would have positive global implications. For example, it is estimated that the effect of fiscal stimulus boosted U.S. imports in 2010 by about $100 billion. Although this represents only about 1 percent of global imports, this added demand undoubtedly made a larger contribution through indirect effects on partner country growth. Perhaps more importantly, the stimulus played a helpful role in underpinning confidence by reducing the risk of a sharper and more sustained global downturn.

Looking forward, sound U.S. public finances will be essential for achieving the G-20 Leaders’ triple goals of strong, sustainable and balanced global growth. Moreover, the absence of a credible, medium-term fiscal strategy eventually would drive up U.S. interest rates, with knock-on effects for borrowing costs in other economies. According to IMF calculations, each percentage point increase in the U.S. debt-to-GDP ratio could drive up long-term interest rates by roughly 3 basis points. Under the baseline IMF forecast, therefore, the expected higher U.S. debt could contribute up to an additional 100 basis points to long-term bond yields by 2016, over and above the expected baseline rate increases. And the longer fiscal consolidation is delayed, the more likely would be a sharper rise in Treasury yields—which could prove disruptive for global financial markets and for the world economy.

In these circumstances, if the U.S. makes a meaningful down-payment on medium-term consolidation—for example, by making clear progress on reforming the tax system and entitlements—it would represent a “demonstration effect” that would add credence to global adjustment efforts.

United States fiscal consolidation therefore could provide a powerful example of the potential benefit of global policy cooperation. As discussed in the October 2010 World Economic Outlook, fiscal consolidation—when analyzed in isolation—tends to depress near-term growth, but boost it over the longer term. Thus, it is understandable that Governments may be reluctant to adopt fiscal adjustment measures in light of the short-term cost. However, if at the same time trading partners adopt policies that support their own domestic demand, the resulting boost to their imports will help to offset their partners' costs of fiscal consolidation, thus making the adjustment more likely to occur. In other words, collective policy action can help to deliver a solution that is better for all.

International policy cooperation

Although it is still early days, there is potential progress to report on international cooperation. In the wake of the crisis, the world’s largest economies are creating a novel mechanism to help guide fundamental economic policies in the post-crisis era, underpinned by what is intended to be a serious and specific process of mutual assessment. I am referring to the G-20’s Framework for Strong, Balanced and Sustainable Growth, launched at their Pittsburgh Summit in September 2009.
The backbone of this Framework is a multilateral process through which G-20 countries have identified objectives for the global economy and the policies needed to reach them. There is a broadly shared consensus that coherent and consistent adjustment efforts will be required by all G-20 economies if the goals are to be attained. In general terms, there is agreement regarding the nature of the required policies.

Framework Policy Matrix

The G-20 members also have committed to the “Mutual Assessment Process”, or MAP, through which their progress towards meeting shared objectives will be assessed. For its part, the IMF has been asked to provide technical and analytical support, with inputs from other international organizations on issues such as labor and product markets, financial markets, and trade.

In an initial stage, G-20 members shared with each other—and with IMF staff—their policy plans and economic projections for the next 3–5 years. These were evaluated by the IMF, against the common framework goals. In the Fund’s view, the projections were relatively optimistic and subject to notable downside risks. In addition, they did not provide for sufficient fiscal adjustment, and implied limited progress towards external rebalancing.

The IMF used two alternative scenarios to highlight the central aspects to judging prospective outcomes. First, a downside scenario quantified the implications of the key risks to the authorities’ projections. At the same time, an upside scenario suggested actions that could improve the outlook and bring all countries closer to their objectives. The basic insight of the upside scenario is that there is a coherent set of alternative policies that reflects a process of optimization in a global setting that—if implemented—would be expected to produce a superior outcome (relative to the baseline) for all G-20 economies.

Growth Payoff At Stake in Policy Choices

In this sense, prospects for whether the MAP upside policies will be implemented depend principally on the answers to two questions. First, do the G-20 authorities accept that the superior alternative policy set is real and realistic? If so, it is in every G-20 member's interest to implement the indicated policy adjustments. Second, does each G-20 member trust that the others will follow the policies indicated for each of them?

At their Toronto and Seoul Summits in 2010, the Leaders affirmed and reaffirmed their intention to aim for the MAP’s superior outcome. In Seoul, they endorsed new aspects that are designed to increase the likelihood that all G-20 members will implement the intended policies, including the use of agreed "indicative guidelines" to gauge progress on reducing imbalances. They also made detailed, country-specific policy commitments that could bring the global economy closer to the upside scenario. These were published as a 49-page attachment to the Seoul Leaders' Declaration.

Of course, the MAP lacks enforcement “teeth”. And its development will take time, as all countries want to be assured that the process reflects their views and interests. But so long as each authority accepts that the upside potential exists, each will have a concrete incentive to seek it.

Returning to the initial topic, early action that boosts prospects of a credible medium-term U.S. fiscal consolidation would enhance the prospects for effective international policy coordination. By demonstrating that the United States is ready to do its part in taking the steps needed to deliver strong, stable and balanced global growth, other countries will be encouraged to follow through on their commitments, as well. And my Fund colleagues and I are convinced that effective international policy cooperation can improve global economic outcomes, and that the chances of success in this effort are the most promising that we have seen.

Speech: Chicago Fed's Charles Evans Says Fed Needs Large Purchases for Price Goal

Remarks delivered by Charles Evans before the Evanston Civic Leaders Breakfast on October 19, 2010, in Evanston, Ill.

I’m delighted to be here today to share with you my thoughts on the economy and offer my perspective on monetary policy. Before I proceed further, let me stress that I will be sharing my personal views with you, and not necessarily those of my colleagues on the Federal Open Market Committee or the Federal Reserve System.

With four quarters of positive growth under our belt and employment beginning to rise, the economic recovery from the recession that ended in June 2009 is certainly underway. However, the pace of recovery in both output and employment has slowed recently. Real GDP (gross domestic product) rose at an annual rate of just 1.7 percent in the second quarter, down markedly from 3.7 percent growth in the first quarter. I expect slightly stronger growth going forward — in the range of 2.0 to 2½ percent in the second half of the year, and 3.0 to 3½ percent next year.

This is a quite moderate pace of growth given the severity of the recession we experienced and in comparison with the economy’s potential growth rate. We need stronger growth for some time before we return to a more normal level of economic activity.

Notably, at 9.6 percent in September, the unemployment rate remains well above the level I consider to be consistent with the Fed’s mandate of maximum employment. To bring the unemployment rate down substantially, the economy needs to grow substantially above the potential rate. But given my outlook for only moderate growth over the next two years, I don’t see unemployment falling below 8 percent by the end of 2012.

Perhaps slower job growth is a new feature of recoveries. Following the two prior recessions, many measures of economic activity showed improvement well before the unemployment rate started to decline. But, in the current environment, slow job growth is symptomatic of a generally weak recovery.

To offer some perspective, let me remind you of the aftermath of the deep 1981 to 1982 recession. In the eighteen months following that recession, growth averaged nearly 8 percent and the unemployment rate declined by 3½ percentage points. In contrast, after 15 months of recovery from the recent recession, growth has averaged only 3 percent and the unemployment rate is only marginally lower than at its peak of 10.1 percent in the fall of 2009. Even after more solid growth materializes, unemployment will likely remain stubbornly high. Discouraged workers will resume searching for jobs, adding to the large number of those already looking for work. Furthermore, the number of long-term unemployed is extremely high, and such workers typically have a more difficult time finding a job.

The housing market will also be a factor constraining employment gains by reducing the mobility of homeowners who owe more on their home than it is worth. New construction and home sales remain well below their historical averages; and, supply and demand conditions could continue to weigh on real estate markets for some time. Low mortgage rates and more attractively priced homes suggest housing market conditions will get better as we move further into the expansion, but improvement is likely to be only gradual.

Recently, many observers have questioned what more monetary policy can do to address the very high unemployment rate. Some have suggested that the financial crisis and the accompanying recession precipitated structural change in the demand for labor, raising the economy’s natural rate of unemployment. They suggest that it has become significantly more difficult to match job seekers with job vacancies over the past two years. If this is true, then monetary policy is not the appropriate tool to address the ramifications of such a change. If, however, structural factors can only explain a modest part of the rapid rise in unemployment, then monetary policy may be able to play a more constructive role.

There are reasons to think that the natural rate of unemployment has indeed risen over the last couple of years. The extension of unemployment insurance benefits during the recession helped to cushion unemployed workers from the adverse effects of lost income. But it also might have reduced the incentive for some workers to seek out new employment, or kept others from leaving the labor force. It is also conceivable that the recession affected different regions and sectors of the economy unevenly or severed an unusually large number of long-term employment relationships, factors making for an especially difficult transition for affected workers.

The historical relationship between unemployment and job vacancy rates is a useful tool for addressing this issue.[1] When labor markets are functioning well, an increase in job openings is accompanied by a decrease in unemployment. It has only been since the beginning of this year that we have seen an improvement in job openings that was not matched by a correspondingly large reduction in unemployment. Based on this, some have suggested that most of the increase in the unemployment rate over the past two years is due to a mismatch between the skills of the unemployed and those needed by employers.

However, there are problems with this view, including the dearth of sectors reporting strong demand for hard-to-find skilled workers and the continued presence of disinflationary pressures that we would not expect to observe if the natural rate were higher and resource slack were smaller. Even if we take the job vacancy data at face value, the size of the deviation from its historical relationship with unemployment is not large enough to suggest an increase in the natural rate to anything like the current rate of unemployment.[2] Therefore, the 8 percent unemployment rate I expect to see by the end of 2012 still leaves us with a very large amount of resource slack. At the same time, measures of consumer price inflation continue to under-run the 2 percent level that I consider consistent with price stability. With inflation expectations stable, inflation is likely to remain below desirable levels for some time. It is not unreasonable to expect 1 percent inflation in 2012. Unless the actual conditions turn out to be very different from my forecast, inflation of less than 1½ percent in 2013 is a strong possibility.

The magnitude of resource slack, combined with the fact that inflation has been running below the level I consider consistent with long-term price stability, suggests to me that it would be desirable to increase monetary policy accommodation. Normally, this would involve lowering the target federal funds rate based on the economic outlook and the historical relationship between policy actions and their impact on the economy.[3] However, at roughly zero, the fed funds rate is as low as it can go. As a result, the current economic environment poses unusual challenges for policymakers.

A key aspect of the current situation that concerns me is the growing evidence that we are in what economists call a “liquidity trap.” In a liquidity trap, the supply of savings continually outstrips the demand for investment, but interest rates near zero can’t fall to equate supply and demand. Liquidity traps are exceedingly rare. The last time the U.S. economy was in a liquidity trap was during the Great Depression, some 80 years ago.

There’s a lot of evidence that we’re in a liquidity trap. Despite the accommodative stance of monetary policy, the amount of credit flowing to households and businesses has yet to expand. Undoubtedly, some of the decline in lending reflects tighter lending standards. However, standards for most loan types are no longer tightening, and anecdotal evidence suggests that credit is more readily available.

Rather, it seems to me that part of the reason for sluggish credit flows is that businesses aren’t particularly interested in increasing spending. As I assess the incoming data and talk to my business contacts, the impression I get is that executives are very cautious in their outlook and spending plans. They appear to be content to post strong profits generated by unprecedented cost-cutting, rather than grow their top-line revenues by expanding capital investment and hiring. Even after substantial improvement in financial conditions, firms are sitting on the cash generated by profits and the funds raised in capital markets. Some of our business contacts explain their reluctance to invest by pointing to uncertainties raised by regulatory actions and government policies. Yet, most admit they would increase spending if demand were stronger.

To be certain, some forms of business spending are already reviving. Inventory rebuilding contributed strongly to growth in previous quarters; but this process is nearing an end, as firms have made substantial progress aligning inventories with sales. Business fixed investment also increased at a solid pace earlier this year, with firms upgrading IT systems and replacing capital equipment in order to maintain competiveness and profitability. Recent data, however, suggest that the surge in replacement demand is beginning to subside. Absent further improvement in consumer demand, business spending is likely to be more moderate going forward.

Consumers also remain reluctant to spend, adding to their savings nearly in proportion to increases in disposable income. The personal savings rate in August, at 5.8 percent, is well above the near 2 percent savings rate that we saw prior to the recession. In fact, personal savings continue to rise even though there is very little interest income to be earned. This suggests that the high savings rate reflects elevated risk aversion caused by the millions of jobs lost during the recession, as well as the $13 trillion wealth loss that accompanied it. Such an increase in households’ propensity to save is accompanied by a decrease in their rate of consumption.

So we have all the ingredients for a liquidity trap: Businesses are cautious about new investment and households are too worried to meaningfully increase consumption. And interest rates can’t fall in the way needed to increase investment and consumption because short-term rates are already at zero: They’ve fallen as far as they can go. If this state of affairs continues, it could very well stifle any reasonably robust recovery. Unemployment would remain unacceptably high, and disinflationary pressures would be reinforced — clearly an undesirable outcome.

These rare occasions of liquidity traps are very different from typical economic recessions. Consequently, they require a unique monetary policy response. Economic theory tells us that in such circumstances monetary policy should aim to lower the real, or inflation-adjusted, rate of interest by temporarily allowing inflation to rise above its long-run path. My preferred way of doing so is to implement an approach called price-level targeting. Simply stated, under this approach, the central bank strives to hit a particular price-level path within a reasonable period of time. For example, if the rate of change of the price-path is 2 percent and inflation has been under-running the path for some time, monetary policy would strive to “catch-up” so that inflation would be higher than the inflation target for a time until the path was regained. This higher inflation rate would decrease the real interest rate, raising the opportunity cost of holding money. This would provide an incentive for banks and corporations to release funds for investment, and in the process spur job creation.

In my opinion, such a strategy is entirely appropriate. The Fed has a mandate from Congress to encourage conditions that foster both price stability and maximum employment. Recently the Fed has missed on both dimensions of this dual mandate, with inflation running below the 2 percent level I associate with price stability, and with unemployment staying well above any reasonable estimate of the natural rate.

Practically speaking, price-level targeting in the current environment would call for a series of large-scale asset purchases to recover the shortfall in inflation. At the same time, we would continue to carry a large balance sheet in order to maintain low interest rates for an extended period.  Most important, we would clearly communicate the path for prices that we expect to attain, in order to enhance the public’s understanding of the Fed’s intentions.

There are operational aspects of a price-level target policy that require much more elaboration and study, including the precise price-level target and how to achieve it. There are also potential challenges that we should be prepared to address. For instance, given the initial uncertainty surrounding the implementation of the new policy approach, inflation may at first continue to be very low. Sustaining our commitment to achieving the price-level target would be critical if we are to achieve success in this case. Conversely, we’d need careful advance planning to ensure that if inflation ran at a more elevated level than expected, we could bring the price level back to the target path. The tools we developed over the last two years to drain reserves from the banking system will prove useful in this regard. It would also be of utmost importance to appropriately use the Federal Reserve’s authorities of macroprudential supervision and regulation during this period to avoid the emergence of financial market imbalances.

For many, my proposal will be a hard pill to swallow. Central bankers generally loathe the idea that even a temporarily higher inflation rate could be beneficial for, or consistent with, price stability over the longer term. We do not want to lose what the Fed under Chairmen Volcker and Greenspan won for the American people by fighting inflation and achieving price stability. The current circumstances, however, require that we fight a different battle — namely, the extraordinary instance of liquidity trap conditions not seen since the 1930s. With potentially beneficial policies that are well grounded in rigorous economic analysis available to us, I cannot stare at our current projections for high unemployment and low inflation and think that they are consistent with the best policies to address the Fed’s dual mandate responsibilities.[4]
Notes

[1] This relationship is often referred to as the “Beveridge curve.”

[2] Making some plausible assumptions, my staff estimates that the level of unemployment consistent with recent data on job openings taken from the U.S. Bureau of Labor Statistics Job Openings and Labor Turnover Survey is likely to be between 6 and 7 percent.

[3] A convenient summary of this relationship is given by the “Taylor rule,” first expressed in Taylor (1993) and later developed further in Taylor (1999).

[4] Academic studies of the benefits of price-level targeting given liquidity trap conditions include Krugman (1998), Eggertsson and Woodford (2003), Svensson (2003) and Auerbach and Obstfeld (2005).
References

Auerbach, Alan J., and Maurice Obstfeld, 2005, “The Case for Open-market Purchases in a Liquidity Trap,” American Economic Review, Vol. 95, No. 1, March, pp. 110–137.

Eggertsson, Gauti B., and Michael Woodford, 2003, “The Zero Bound on Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, Vol. 34, No. 1, pp. 139–211.

Krugman, Paul R., 1998, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, Vol. 29, No. 2, pp. 137–187.

Svensson, Lars E. O., 2003, “Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others,” Journal of Economic Perspectives, Vol. 17, No. 4, pp. 145–166.

Taylor, J. B., 1993. “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, Vol. 39, June, pp. 195-214.

Taylor, J. B., 1999, “A Historical Analysis of Monetary Policy Rules,” in Monetary Policy Rules, John B. Taylor (ed.), Chicago: University of Chicago Press, pp.319-341.