Chicago Fed chief predicts sluggish economy all year

Chicago Fed chief predicts sluggish economy all year

An unstable marketplace is making it difficult for the Fed to develop monetary policies that can stabilize the economy in the short-term, said the chief executive officer of the Chicago Federal Reserve Bank.

“The disruptions in financial markets that began last August have greatly restricted the flow and increased the price of credit and liquidity,” said Chicago Fed president and CEO Charles L. Evans, speaking to area business leaders at Harper College’s Economic Forum in Palatine.

“Clearly, this has complicated policymaking.”

Evans said that the dual mandate of The Federal Reserve is to foster financial conditions that promote both maximum employment and price stability by setting an appropriate target for the federal funds rate, or the interest rate at which banks make overnight loans to each other.

In a healthy economy, the spending capacity of households and businesses is supported by the channeling of funds from lenders to borrowers.

“But as we have seen over the past nine months, at times financial disruptions occur,” said Evans. “Such disruptions can hinder the flow of financial capital to creditworthy borrowers and reduce their ability to consume and invest. Such situations pose special challenges for policymakers.”

The federal funds rate, Evans said, is determined by three key factors: maximum employment, price stability and the neutral funds rate.

Maximum employment can only be achieved through economic growth at its maximum sustainable rate, or the rate of real growth the economy can maintain in the long run without leading to an increase in inflationary pressures, said Evans.

“Price stability is achieved when inflation does not significantly distort the economic behavior of households or businesses,” Evans said.

Prices are considered stable when they are around 1.5 to 2 percent, which is similar to the neutral funds rate, or the rate consistent with an economy operating at its potential growth path and with stable inflation, which is in the neighborhood of 2 to 2.5 percent.

Financial stress can alter the mechanism by which the federal fund rate is calculated by “boosting the risk premia built into private borrowing rates and substantially increasing the demand for liquid assets that can be easily turned into cash and used to pay liabilities,” said Evans.

The housing bust, he pointed out, which acted as the catalyst for the current financial circumstance, has forced the Fed to drop interest rates by 325 basis points since September 2007 and to implement initiatives to increase liquidity to strained financial markets.

These new policies include changes to the Federal Reserve’s discount window and establishing the Term Securities Lending Facility and the Primary Dealer Credit Facility so as to lend to the primary security dealers, or investment banks, who have been hindered by serious liquidity problems in the marketplace, said Evans.

The Fed has also consulted closely with foreign central banks during this period.

“We instituted swap arrangements with both the European Central Bank and the Swiss National Bank to help provide dollar-denominated liquidity to European Banks,” Evans said.

“Together, all of these initiatives have lowered short-term market interest rates, reduced the cost and lengthened the maximum term of banks borrowing directly from the Fed, broadened eligible collateral and expanded lending to non-depository institutions,” said Evans.

The Fed president compared the current situation to that of the 1990 recession, which was later characterized by its snail-like pace as a “jobless recovery.”

“We have seen a broader disruption of credit flows, even than those of the early 1990s,” Evans said. “This suggests we may again be in for a period of weak growth.”

Some encouraging signs are the measures the Fed has put in place to boost liquidity, which weren’t in place in the early 1990s. This has created a monetary policy that Evans believes is “accommodative and appropriate in order to address the way we currently see the sluggish economy unfolding in 2008.”

While the Chicago Fed sees slow economic growth in the near term, eventually the cumulative adjustments in house prices will bring more buyers into the market, thus stabilizing activity, said Evans.

Such stabilizing factors include:
• The diminishing drag on the economy by the residential construction sector.
• The repairing of balance sheets by financial market participants to loosen credit conditions.
• A monetary policy that is accommodative and supportive of growth.
• The current strong rate of productivity growth.
• The effects of the fiscal stimulus bill.

The Fed’s forecast also assumes that energy and commodity prices will stabilize some time over the medium term, Evans said.

“I am confident that policymakers will continue to respond to future unexpected changes in the environment for growth and inflation as needed in order to promote sustainable growth and price stability,” he said.

Jeremy Stoltz, Staff Writer

Posted on Wednesday, May 21, 2008 (Archive on Wednesday, May 28, 2008)
Posted by jstoltz Contributed by jstoltz

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