How the Fed can soothe nervy markets

In a speech at The Bankers Club in Hong Kong, Charles Evans of the Chicago Fed outlines why the US central bank needs to implement a more transparent and accountable policy.
How the Fed can soothe nervy markets

An audience at The Bankers Club in Hong Kong this week heard how the US central bank could apply more transparent and accountable policy to reassure jittery markets, although not everyone was in agreement.

Giving the address was Charles Evans, president and CEO of the Federal Reserve Bank of Chicago. His argument was that the Federal Open Market Committee (FOMC) – which oversees the Federal Reserve’s buying of Treasuries – should commit to a 7:3 threshold rule.

By this he means the Fed should raise its inflation tolerance by a percentage point to 3%, while tying its target interest rate to an unemployment goal of 7%.

It should commit not to hike rates until unemployment falls below 7%, and any commitment to low rates should be dropped if the outlook for inflation rises above 3% over the medium term. This provides parameters to show markets it won’t retract its accommodative stance prematurely.

He argues this would be preferable to the conditional statement the FOMC has been trotting out since January, that it expects prevailing economic conditions to keep the Fed funds rate at “exceptionally low levels at least through late 2014”.

The Fed announced longer-term goals at its FOMC meeting on January 25, when it opted to use a 2% inflation target to determine interest rates.

Evans notes that while the US financial system appears to be flush with liquidity on the back of monetary easing and is ready to stimulate economic growth, the Fed’s accommodative actions have so far failed to bring down a stubbornly high unemployment rate of 8%. At the same time, private sector estimates point to GDP growth of less than 2% for 2012.

This proves that the Fed needs to improve on its forward guidance to provide the market with greater clarity. “For this liquidity to be sufficiently accommodative, the public needs to expect that [the Fed] will keep it in place for as long as is necessary to restore the economy to a sound footing,” says Evans. 

In its “operation twist” programme, the Fed has been buying Treasuries with maturities of 6-30 years using proceeds from selling/redeeming Treasuries with a maturity of three years or less. The aim is to suppress longer-term interest rates and stimulate economic recovery.

But Evans, a supporter of another round of quantitative easing, urges the Fed to take stronger steps such as buying more mortgage-backed securities to support recovery.

He suggests these should be “open-ended” purchases that see the Fed continue to buy at a certain rate until clear evidence of steady monthly declines in the jobless rate for two or three quarters.

At this point the central bank should still keep its Fed funds rate at zero until unemployment falls below 7% or the mid-term inflation outlook worsens and rises above 3%.

During the Q&A session one banking executive argued that using an explicit interest-rate target as a way to spur economic activity was over-simplistic. He noted that banks are still not lending, no matter how much money the Fed pumps into the financial system.

Evans replied that the Fed's actions were designed to increase aggregate demand, supporting his argument that 3% is a better target inflation rate than 2% because greater inflation pressure would be generated. 

Prior to becoming head of the Chicago Fed in September 2007, Evans served as the bank’s director of research and senior vice-president, supervising research on monetary policy, banking, financial markets and regional economic conditions.

While he is serving on the FOMC, Evans does not become a voting member on its rate-setting panel until next year.

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