C. Peter McColough Series on International Economics: The Great Inflation Debate

Wednesday, September 9, 2009

BLINDER: Good morning, everybody. And it is early, I know. Welcome to the council. It's my pleasure this morning to introduce Charles Evans, the president and CEO of the Federal Reserve Bank of Chicago, which I'll do in a moment.

First, I want to mention that this meeting is part of the C. Peter McColough Series on International Economics. I'm not sure we'll touch international economics today, but it's close enough.

The next meeting in that series will be on October 8th and will feature Christine Varney, who's the assistant attorney general for Antitrust, remember that, at the -- (laughter) -- at the U.S. Department of Justice.

The other thing I'm duty-bound to remind you is, please turn off your cellphones, beepers, PDAs, iPhone. My God, whatever you're carrying that beeps and screeches, please turn it off. Thank you.

Charlie Evans, as he's known, is the ninth president of the Federal Reserve Bank of Chicago. I want you to dwell on that for a moment. The Federal Reserve System opened for business in 1914.

He's only the ninth president. There is a certain stability in the organization. And of course, that makes him a member of the Federal Open Market Committee, in alternate years, given that the City of Chicago -- that's another story, never mind about that.

Charlie is an economist. I don't know whether that's a good thing or a bad thing to be. I'm an economist myself. I don't know whether that's a good thing or a bad thing to be these days.

We certainly didn't do much to avert the mess. But I think economics has helped fix it or is -- I should put that in the present tense -- is helping to fix it.

So I think we're a little bit of goat and a little bit of hero at the same time.

In any case, Charlie is an economist. He came to his current position from being director of research and senior VP at the bank. And he's been a deep thinker on monetary policy for some years. You have his brief bio in front of you. And just let me tell you, for those of you who are not in the club, which is most of you, he's published in all the best places. These things listed here are the best places where the best research is published.

On the committee, I think very few people in the media, if any, I think have labeled Charlie as either a hawk or a dove. I think he's very much a centrist who's swayed by evidence, which is a good thing. Some people have said that if you're in between a hawk and a dove you're a turkey. (Laughter.) I've never agreed with that. I think it's much more like a soaring eagle.

And with that, I'm very glad to present Charlie Evans. (Applause.)

CHARLES L. EVANS: Thanks, Alan. Thanks for that kind introduction. I don't think I've ever heard that turkey analogy before. (Laughter.) And thanks to the Council for inviting me here to speak.

You'll note that I became president and CEO of the Federal Reserve Bank of Chicago exactly two years ago. While I can assure you that there's no correlation, this period has been among the most interesting and extraordinary in the history of the Federal Reserve system. Though much of what the Fed has done in the last two years has been under scrutiny from the government, the media, the general public and others, and while the debate has been loud and at times far ranging, our mandate from Congress has remained quite clear. The Fed and its monetary policy arm, the Federal Open Market Committee, is to promote monetary and financial conditions that facilitate the attainment of maximum employment and price stability.

For about the last 30 years, there has typically been no conflict in pursuing each of these goals with a single tool: the short-term interest rate. This is because increased -- this is because rising inflationary pressures are often accompanied by unsustainably high growth, and economic slowdowns are typically associated with disinflationary pressures. Nevertheless, this simple description of the way monetary policy responds to growth and inflation prospects belies the fact that discussions within the FOMC often touch on a wide range of drivers for inflationary pressures.

A small set of relevant factors should include money growth, resource (slack/lack ?), inflationary expectations, energy and commodity price shocks, and assessments of the credibility of future policy commitments. And there's a surprising amount of disagreement and uncertainty over the exact roles these forces play.

I'm not talking out of school on this issue. A careful reading of FOMC transcripts over the past 20 years will reveal many different views on inflation, and perhaps this is not surprising. The economics community itself continues to debate strongly the importance of different transmission channels for inflation. Policymakers who were informed by these developments and, in many cases, have contributed to the scholarly research in this area continue to have a healthy discourse over the issues and facts.

During normal times, this debate rarely spills over into major disagreements about policy, because inflation evolves gradually. But today we are not in normal times. The inflation debate has broken out on the front pages of newspapers, with major disagreements among distinguished experts.

For example, in recent New York Times op-eds, Paul Krugman said that large resource gaps have made him worried about deflation, while Allan Meltzer said that massive growth in the monetary base has made him worried about inflation. Certainly the stakes could not be higher. We have ample evidence of the harm that deflation can cause. The history of the U.S. economy in the 1930s is a case in point, where the price level fell by over 25 percent, contributing to the severity of the Great Depression.

But history also shows us the damage that high inflation can wreak on the U.S. economy. From 1965 to 1980, inflation rose from about 1-1/2 to 10-1/2 percent. Many economists refer to this period as "the Great Inflation." The costly process of breaking "the Great Inflation" and then subsequently the achievement of price stability took the better part of the next 17 years.

So it is quite disconcerting when highly regarded analysts talk about the possibility of another debilitating deflation while others, just as highly regarded, suggest that, even though we have avoided the Great Depression 2.0, the U.S. economy may be facing "the Great Inflation 2.0." This morning, I would like to frame these two extreme views on inflation risks within the language economists and policymakers use to discuss these issues. After highlighting the terms of these disagreements, I'll provide some commentary on the lessons learned from the historical record on inflation.

In brief, I think neither a harmful deflationary episode nor a repetition of "the Great Inflation" is very likely. Stimulative policies combined with the economy's resilient market forces will, over time, reduce resource gaps. Deflation has been averted.

And as the economy continues to improve, and when we see rising inflation pressures, that policy will respond aggressively. Having said this, the main threat to these outcomes would be if clear danger signals were ignored or if central bank independence were compromised.

And as always, my remarks today are my own and do not reflect those of my colleagues on the Federal Open Market Committee or the views of the Federal Reserve System.

Now, it's natural to start by considering the factors that affect inflation. What do economists say? Well, macroeconomists are a contention bunch. The most accomplished scholars in this field share two overpowering attributes. First, they're highly intelligent. And second, when the subject is monetary policy and inflation, they appear to agree on very little. And Paul Krugman on Sunday reaffirmed this in his New York Times Magazine article. And in fact, I had to discuss this with my staff, and they disagreed with me, which is -- (laughter) -- sort of typical.

Nevertheless, I think there are two strongly held articles of faith that are, in fact, shared by the vast majority of economists.

First, large, sustained and explosive growth in money is associated with high and variable rates of inflation. The logic and evidence are overwhelming. Economies that are running the printing presses on overdrive, usually to finance unsustainable fiscal deficits, generate great instability in prices and high inflation.

The second article of faith is that high unemployment rates and slack capacity utilization, which we refer to as resource gaps, are often associated with falling inflation. A prime example of this is the 1981-'82 recession, when unemployment rose to nearly 11 percent as the Volcker-led Fed broke the great inflation.

Clearly, these two articles of faith can help frame the current discussion of inflation risk. On the one hand, the explosion of the Federal Reserve balance sheet has led to an enormous increase in bank reserves in the monetary base. Left unchecked, these monetary facts seem to scream inflation risks. On the other hand, the unemployment rate is 9.7 percent, and manufacturing capacity utilization is currently only 65 percent, which is the lowest level since this statistic started to be officially computed in 1948.

These resource gaps suggest that disinflationary winds are blowing with gale force effect.

In trying to assess inflation risk from monetary conditions and resource slack, we must remember that these factors are strong predictors only in relatively extreme cases. So it is the fact that we currently find ourselves in a situation with competing extreme cases -- both large resource gaps and big expansions in the monetary base -- that leads to today's great inflation 2.0 debate.

In a few minutes I'll return to how I see this conflict turning out. But these two articles of faith provide only a partial understanding of the factors that determine inflation during more usual times, so it is useful to first describe a relatively mainstream view on how inflationary pressures emerge under more typical circumstances.

Although inflation is ultimately a monetary phenomenon, many factors come into play when thinking over its evolution over the medium term. The most important ones are changes in resource costs, wage- and price-setting behaviors, and inflation expectations. As we'll see, these forces are related to both articles of faith that I just discussed. However, there are disagreements over how much weight to place on each factor and also how to interpret the fundamentals underlying each of them.

Let me begin with resource costs. When firms set prices for the products they sell, they pass along current and expected future changes in input costs, including labor costs. As a result, market prices and inflation move in the same direction as these resource costs.

It's natural to use movements in measures of aggregate resource utilization, such as unemployment and (capacity ?) utilization to capture changes in the market balance between supply and demand. In this way, resource costs are linked to resource gaps.

Unfortunately, for a host of theoretical and statistical reasons, these measures of resource utilization are imperfect proxies for supply and demand pressures. As a result, economists will disagree on the importance of these measures for inflation determination at a given point in time.

In addition to direct cost pressures, price setting is influenced by expectations of future underlying inflation. Many things can influence expectations about the future path of inflation. It is a veritable kitchen sink. In addition to the resource costs I just talked about, other important influences are changes in money growth, fiscal factors, and central bank credibility and independence.

Higher money growth today may lead people to conclude that inflation will increase in the future.

Unchecked fiscal imbalances can also lead to higher expected inflation if the public believes that at least some of the fiscal deficit will be paid by printing money. And inflation expectations can increase if everyone believes that a central bank will refrain from increasing policy rates, for political reasons, even in the face of inflationary pressures.

Expectations are clearly a powerful determinant of inflation. But they are inherently unobservable. Expectations reflect a confluence of both objective market data and subjective beliefs of market participants.

Similar to other important economic forces, like the output gap, the lack of observability and difficulty in measuring inflation expectations represents a powerful challenge for monetary policymakers.

Here's how I approach this issue. Initially we can attempt to directly assess each important force for future inflationary pressures. This approach could construct a risk assessment or dashboard for inflation pressure indicators and would include all of the factors cited above, at a minimum, along with an assessment of their importance.

Although there will be disagreements, I find this instructive approach facilitates rigorous and robust debate. An alternative approach is to be agnostic about the factors that influence how inflation expectations are formed.

Instead we would simply try to infer expectations from surveys and financial market data. Although this is intriguing, there are limitations in using this approach to the exclusion of more direct measures of inflationary forces.

In particular if monetary policy is so fully credible that everyone believes inflation will not deviate from its goal, inflation expectations will not respond to changes in the economic environment.

For example, many believe that the European Central Bank's commitment to price stability, over the medium term, is so strong that measures of Eurozone inflation expectations rarely move.

But this sort of stability in expected inflation does not mean that the central bank can relax its vigilance against inflationary forces. On the contrary, this stability is a consequence of that very vigilance, and anybody who listens to the ECB would understand that.

We cannot rely solely on direct measures of expected inflation without some sort of risk assessment that monitors indicators of inflation pressures. Fortunately, these two approaches for assessing inflation expectations are not mutually exclusive. Indeed, they are complementary.

So one of the big questions is to ask what the historical record says about the importance of these different factors. And now would be a good time to turn to a couple of quite salient historical examples.

The "Great Inflation" in the U.S. from 1965 to 1982 provides a good example of how a long, sustained increase in money growth tends to increase both contemporaneous inflation and expectations of future inflation. Over this period, the price level more than tripled, with the inflation rate peaking at over 11 percent in 1980. This rise in the price level was accompanied by strong growth in both narrow and broad monetary aggregates. The monetary base, like the price level, more than tripled over this period, and M-2, which is a broader measure of transaction money, more than quadrupled.

Increased bank lending was a key factor in broad money growth and "the Great Inflation." During normal times, an increase in the monetary base results in an increase in broad money, because banks generally lend out almost all of their excess reserves. But if, for some reason, they choose not to do so, then broad money will not increase as fast as the monetary base, and the likelihood of a rise in inflation is greatly diminished.

An example of this occurred during the early part of the Great Depression, when base money grew significantly but the broad money stock actually fell by one-third. We also find a disconnect today between the monetary base and broad money. Over the past year, monetary base has nearly doubled as the Fed has rapidly expanded its balance sheet. But given the sluggish growth in bank credit, broader money has risen much less, by only around 8 percent. So we'll need to see much more expansive bank lending if the monetary base expansion is to trigger an inflation response. And we've yet to see this happen in the current economic downturn.

1979 to 1982 provides a different example of the tenuous link between money and inflation. Between 1980 and 1982, the inflation rate peaked -- I'm sorry, the inflation rate declined from its peak at 11.6 percent to 4.8 percent. Yet this disinflation was accompanied by an increase in broad money growth, with M-2 growth rising from 7.8 to 8.8 percent.

The explanation is that this was a period of restrictive credit, with real interest rates soaring to over 10 percent. Partly as a result of this tight credit environment, economic activity weakened considerably, generating substantial resource gaps. Restrictive credit conditions and resource gaps dominated the influence of relatively high rates of money growth.

This episode constitutes a caveat for the monetary explanation of inflation pressures. You need to consider both demand and supply pressures for money. You can't ignore the prices of liquidity and credit. Indeed, empirical research has found that outside of extreme cases, money growth generally does not have such predictive power for inflation over the short and medium terms.

I didn't go back and check the former vice chairman's speeches during his tenure, but my guess is I've already mentioned money more times than he did during his entire tenure on the Board of Governors. (Laughter.)

Now, history also cautions us about relying purely on resource lack as the sole guide to inflation pressures. For example, although high rates of unemployment are typically viewed as disinflationary, the stagflation of the 1970s serves as a counter-example. The problem here is that measures of resource slack can be misleading.

Athanasios Orphanides argues that something of the sort happened in the 1970s. According to his story, economic weakness was interpreted by the Fed as evidence of a substantial output gap, but this period of economic weakness coincided with a major structural slowdown in productivity growth and rising structural unemployment. In fact, resource and output gaps were overestimated, leading to an overly accommodative monetary policy response.

Is this sort of dynamic likely to be a factor in the current situation? Although some of these forces may be present, I'm skeptical of their quantitative significance. Recent studies done at the Chicago and San Francisco Feds find little evidence that sectoral reallocation or other factors are increasing the unemployment rate or reducing measured output gaps on a very large scale.

So I believe that resource gaps remain substantial today. That's an enormous mitigant for inflation pressures.

Now, before concluding, let me turn to the relationship between central bank independence, fiscal policy and inflation outcomes. Independence of the central bank is always important. Periodically, the central bank must take tough actions that are needed for future and medium-term prosperity, even though these actions are painful in the immediate short term.

A classic example is the need to increase policy rates on early signs that inflation could be rising substantially, even though the real economy remains weak. Here there may be pressure for the central bank to inappropriately reweigh its dual-mandate objectives and postpone the tightening until matters in the real economy improve further. The central bank that lacks independence, and so forbears on tightening policy, has effectively abandoned its low-inflation goal and, as a result, both expected and actual inflation can increase.

Fiscal pressures can also pose problems for central bank independence, if large deficits are expected into the foreseeable future. Even if the central bank pursues a tight monetary policy, both current and expected future inflation can still increase if the public believes that the central bank will be forced to monetize the government debt sometime in the future. Tom Sargent and Neil Wallace coined the term "unpleasant monetarist arithmetic" for this process. In principle, very large debt levels could compromise the independence of even the strongest central bank, if the choice is between monetizing the debt or inducing a costly monetary contraction.

So let me conclude now. I started today by describing two extreme views for the future of inflation. One view, motivated by the expanding fed balance sheet, has inflation greatly increasing in the future. The other view, motivated by a sluggish economy and large resource gaps, has strong disinflationary forces.

My view is that large resource gaps have been met by a large growth in reserves. In an effort to prevent a repeat of the Great Depression, the Fed acted quickly and decisively over the past year to provide liquidity to markets and to prevent systemically important institutions from failing. These are things that the 1930s Fed did not do. It is precisely these actions that have greatly expanded our balance sheet. So the coexistence of the motivating observations for the two extreme inflation views is not very surprising.

But now for the hard part. Just as the Fed acted responsibly to prevent a potential deflation, it will do so to prevent a future increase in inflation above our price stability objective.

Unfortunately, this sounds too much like "Just trust us to do the right thing." This is uncomfortable for everyone, but it is a natural dilemma at this point in the economic cycle, when it is yet too soon to actually begin removing policy accommodation.

I'm confident that the Federal Reserve will achieve the price stability component of our mandate. Our response will embody three principles: prepare, monitor and act.

Chairman Bernanke recently testified on the tremendous preparations that the FOMC is undertaking in order to be sure our balance sheet can be reduced and that appropriately restrictive monetary policies can be implemented when necessary.

And the FOMC is monitoring economic and inflation conditions for the signs that adjustments in police are needed. I hope my comments on inflation expectations and direct assessments of inflationary pressures have been helpful in this regard.

Finally, the Fed will act in a timely and appropriate manner to achieve our dual mandate objectives of maximum employment and price stability.

Thank you very much. (Applause.)

BLINDER: Well, thank you very much, Charlie. I think you demonstrated, as I said before, not a hawk, not a dove, but an eagle --

EVANS: (Chuckles.)

BLINDER: -- who's always watching.

I'd like to start by asking you to describe a bit the elements, as you see them some time down the road, of the Fed's exit strategy, and if you'd -- as you do that, if you could just give us some indications of how the Fed might know or find it difficult or easy, whichever, to know whether it's going too fast or too slow through the exit door.

EVANS: So I think at the moment the big challenge is going to be to monitor the economic situation. I think the recovery is beginning to start. I'm looking for growth over the next 18 months to be in the 2-1/2 to 3 percent range, but the unemployment rate will continue to rise, probably, for the next six months, peaking a little bit over 10 percent and then coming down. I think unemployment will continue to be high for a very uncomfortable period of time.

At the moment inflationary pressures seem to be relatively muted. In fact, as I mentioned earlier, I think a number of people are worried about disinflationary forces.

So the question will be, when is the current monetary policy accommodation no longer appropriate? When is the recovery fully on track and robust enough in building momentum for unemployment to recede to the point where the accommodation should be withdrawn? I think we'll be looking for signs of inflationary pressures, as I talked about. We'll be looking at expectations, but also every other potential indicator of inflation. And then we'll start talking about removing accommodation.

Removing accommodation's a very important aspect of this, because the Funds Rate is effectively zero, and our balance sheet is very large. There are a lot of questions. Your question obviously is also about the size of the balance sheet and how we unwind the large size of our balance sheet. Normally, if we had to reduce our balance sheet before we increased interest rates, we'd have to sell a number of assets. I think currently we have tools in place by offering interest on reserves to banks, which -- we could begin more removal of accommodation on the way to outright more restrictive monetary policies.

But those are some of the things that we'll be looking at. And we'll have to be trying these new tools -- interest on reserves is going to be an important element of this -- in order to make sure that, you know, there are more restrictive credit conditions associated with a more robust recovery. But that's some time down the road.

BLINDER: By the way, I forgot to mention, this whole session is on the record. That's not a surprise to our speaker; he knows that. But just so everyone in the audience knows that.

But could I just push you on that a little bit, about the -- since they are new tools --

EVANS: Right. Right.

BLINDER: -- exactly as you said, what do you think of -- are the guideposts that will tell you we're either moving too fast or we're moving too slowly?

EVANS: So in -- you know, in some sense that's the -- stated that way, the question is sort of a more normal "How does policy respond," you know, "Should you be raising the Funds Rate rapidly?"

Obviously, in the 2004 to 2006 period, the Funds Rate -- it took us over two years to increase the Funds Rate by 425 basis points. I think that that was probably too slow. I think that it was correct at the beginning, but somewhat later, looking back on it, we might have been well served by being slightly more aggressive and getting to a more restrictive policy stance more quickly. I think that the -- with regard to the new tools, when policy begins to tighten, we'll increase the Funds Rate and we'll increase the interest rate that we offer on reserves.

We'll be looking at what the size of the excess reserves are and whether or not credit conditions are in fact restrictive.

If they're not sufficiently restrictive, we have other ways of also tightening, reducing our balance sheet, through repurchase agreements on some of these assets. We can basically lease these assets out, for a period of time, if we choose not to outright sell them.

So I think that we can provide for appropriately restrictive credit conditions. We're going to want to be a little more aggressive than we were in the 2004-2006 period though. That would be my expectation. Of course, we're going to be looking for how robust the recovery is.

BLINDER: Sure. Thanks.

You mentioned in your talk the central importance of Federal Reserve independence in maintaining, especially when necessary, politically unpopular anti-inflationary policies.

The Federal Reserve is not very popular in Congress these days. Paradoxically in, I was going to say, audiences like this, I think that's probably right. But in financial audiences among economists, most of us think of the Federal Reserve as being superheroes lately. But in the Congress, there's a much dimmer perception of the Fed.

I'm wondering if you see this as a threat in any way to Federal Reserve independence.

EVANS: Well, I think, it's always a challenge to, you know, look at a period of an economic downturn and, you know, provide accommodative conditions and then face rising inflation pressures, in part because of those accommodative conditions.

It's important that the central bank be paying attention to both sides of its mandate: maximum sustainable growth and price stability. So it's that price stability component that causes us to require more restrictive credit conditions.

That's always unpopular, as you know from your own experience. I mean, when you talk to businesspeople, consumers, higher interest rates mean higher borrowing costs. And that restricts people's activities.

And so that's not popular. And the current period is obviously one where the economic downturn has been so severe, the contraction so large, that everybody is very concerned about that.

And I'm concerned about it, too, but what's important going forward, in order to make sure that we have sustainable growth for a long period of time after this, is that we achieve price stability, that we not allow inflation to either be too low through disinflation or to high above our objective. And that's going to require some tough decisions.

And so the Fed -- I'm confident that we will, you know, continue to obey our dual mandate. That's the law. That's the Federal Reserve Act. And until that changes, that's what we'll be doing.

BLINDER: Okay, thank you. I'm going to open this up now to questions from the audience. Just a couple of reminders. There's a microphone -- or more than one microphone. So when I call on you, please wait for the microphone to arrive and speak into it. And tell us who you are. State your name and affiliation. And finally, I'll make the ritual -- I'll make this in the form of begging, since I've sat through a lot of these. Please keep the questions short.

Let's start with Jeff Shafer, near the front.

QUESTIONER: Jeff Shafer, of Citi. I was a little shocked, Alan, when you said there was nothing international about this session. I haven't heard anything international yet, but I'll bring it in. (Laughter.)

A few years ago, I would have probably given the same speech you gave, and talked about inflation as being generated by resource constraints that I thought of as being capacity utilization and unemployment within the country. We saw a good dose in '06 -- '07 and in the last year, of some inflationary pressures coming from resource constraints that were in fact global, in commodity markets. And I'm wondering, is it possible to think just nationally in terms of inflation again, or in the next recovery will we have to deal with the fact that there's a potential for global resource constraints from very rapid growth in other parts of the world?

EVANS: So, you're right, we definitely saw pressure from higher energy prices, higher commodity prices that showed through to headline inflation. And in fact, it showed through to core measures, as it increased to about 2-1/2 percent year over year for some period of time.

I was a little bit concerned that those higher commodity prices, generated by strong global demand -- you're absolutely right -- was affecting inflationary expectations. So that can find its way into underlying inflation and be a real problem for achieving our price stability objective.

I think we have to be careful in thinking about the global situation, at least that particular situation. It's obviously a change in relative prices.

The global economy is expanding tremendously: China, Russia, India, Brazil, all these countries that are, you know, increasing in size and importance. And increasing their demand for that scarce resource is driving up the price of commodities and energy.

That can lead to a one-off increase in those relative prices, which could lead to inflationary pressures, if monetary policy doesn't respond appropriately. But it's exactly that type of appropriate response that's necessary.

So you're right. It's not just resource lack. And that's one reason why those empirical measures don't have a great, strong relationship for inflation. It's very artful to come up with these inflation outlooks. And that's what we have to spend a considerable amount of time discussing.

BLINDER: The gentleman right here. And then I'll come up to the other side.

QUESTIONER: Hi. I'm David (sp). (Inaudible.) Thank you for your remarks.

You didn't address the dollar in the context of its inflationary implications. Many people think the dollar will lose maybe half of its value in coming years. Would that add to the price level in the U.S.? And is it -- isn't it important to bring the dollar into a discussion of inflation expectations?

Thank you.

EVANS: So you're right that changes in relative prices that have an impact on -- you know, on inflation as it's measured, are important for us to consider. And so that type of relative price change would have an impact. To the extent that those consequences are due to the stance of monetary policy, we have to adjust that. We have to be paying attention to how they affect inflation, relative to our objectives.

My own guideline for inflation is that we should pursue something close to about 2 percent. And you know, at the moment, we're under- running that. And so there's some room for inflation to increase with the current situation. But we'll be mindful of those developments and be, you know, quite concerned about them, if that's appropriate.

BLINDER: Joe (sp), he's not going to reveal the Fed's target for the U.S. dollar. (Laughter.)

EVANS: Well, we're not allowed to talk about that, as we all know. But I chose not to start my response that way. But I'll end it that way. (Laughter.)

BLINDER: I was reminiscing. When I was in the Federal Reserve, any time I said anything obliquely about the dollar, which was almost never, I got a call from Larry Summers reminding me I'm not supposed to talk about the dollar. (Laughter.)

The gentleman right here in the front.

QUESTIONER: Jaime Juan, Granite Associates. You mentioned the Krugman article. I was wondering if you could comment on the ideology within the Fed. Did he over-dramatize the situation? And which thinking dominates today at the Fed?

EVANS: It's an interesting question. I've never been that enamored with the, you know, attempt to categorize economists as saltwater and freshwater ideologies. I mean there might have been a time when that was useful. I also have trouble with the old debate, which may or may not still be in textbooks, between monetarists and Keynesians. There's so much overlap, actually.

And in fact, in the research that I've done, I'm not quite sure where I fall on his ideology. I have work that is influenced by the freshwater side, in his nomenclature, which is general equilibrium model with optimizing agents, but I also have a lot of ad hoc rigidities which seem to be important, as your work on sticky prices, Alan, obviously, has indicated. So I've got nominal rigidities through wages and sticky prices and also sluggish adjustment. And I think that that's sort of his saltwater perspective as well. So I think that there's's actually been a reasonably good synthesis across those schools of thought.

Now, what I think is very hard -- and I've spoken about this in the past -- is integrating financial factors into our disciplined thinking about the economy is very hard. Understanding the nature of debt contracts and incentive problems is hard from a theoretical standpoint. It's hard empirically.

When you -- I remember -- before I became research director, I've been with the Chicago Fed since 1991, and I advised by predecessor, Michael Moskow, through the '97-'98 Asian financial crisis and LTCM. And when spreads blew out, the question on our minds was, what's this mean for consumer spending and businesses?

And the answer typically was, when I look at my models, my statistical models, those factors don't show up, because spread variables have a very tenuous relationship to economic activity on average over many, many business cycles.

During the current situation, they're very important. How do you all of a sudden figure out quantitatively how much weight to give something which is a once-every-20, -30, -50-year event? It requires a lot of judgment. That's why we talk about this, and we debate it quite a lot.

What -- you know, I thought it was very interesting, as Paul Krugman -- all of his articles are fascinating; they have a very interesting style. It wasn't sufficiently constructive in the sense that I knew exactly how to go forward from that perspective. I'll be looking for more on that.

BLINDER: Chicago's on a lake, but it looks like an ocean. (Laughter.) Very big lake.

The gentleman right over here.

QUESTIONER: Yeah, I'm Richard Hoey at BNY Mellon. When we talk about inflation in the Fed context, it's usually, you know, targeting consumer price inflation or giving forecasts, as opposed to official targets. But when we look at what -- the economic history of the last 15 years, asset inflation and asset deflation have been mighty important. And if you go back about five years ago, the Fed view was, it's inconvenient for us to address bubbles, so let's assume we can't identify them; let's not do anything about them; let's just clean up the economic problems that create -- are created by the bubble bust.

As you look at that from today, that's not a very popular view of the approach that should be made. So if we have an inconvenient situation, in which rises and falls in the Fed Funds Rate generate a succession of bubbles and busts while you're trying to keep sound money on a purchasing value by keeping kind of a(n) average consumer price inflation, I'm kind of asking for an update: What do we think about that now, given the evidence that the strategy of "Let the bubble run and we'll clean up the mess afterwards" doesn't look like a good idea in 2009?

EVANS: Well, you've covered a lot of territory with that question, from inflation to asset price collapse, and so I wish I had more time to discuss that.

Well, there are a number of issues. One is -- and it's almost a dirty little secret -- which is, monetary policy -- the interest rate is only one tool. And one tool can really only address one objective, and yet we have a dual mandate, which is to provide for maximum sustainable growth and price stability. So we have to be very careful in how we balance those off.

Now when we add into that asset prices and financial stability and conditions like that, obviously we're somewhat deficient on that one instrument basis, so we have to bring other policies to bear.

I think obviously, you know, better supervision is an important part of this. For the financial institutions within the regulatory umbrella, I think we have to be much more careful and somewhat more conservative. There are calls for higher capital ratios coming out of the G-20. I think that there are a lot of interesting ideas about contingent capital; debt, which can be converted into capital, either on a supervisory or market price trigger.

I also think that part of the supervisory plan where institutions have to think and prepare something known as a funeral plan -- how do I unwind an institution for a particular scenario -- I think that serves as a very useful point of discussion between the supervisor and the institution. They take very seriously that here's how you would resolve a complex organization, and the supervisor understands that better, or they say, "You didn't look at this. Why not?" It stimulates a very good discussion. Supervision's an important part of that, capital and market conditions as well, and appropriate monetary policy that doesn't let things get out of hand.

I agree with you that it was previously -- if not a consensus view, it was a strongly held view that we couldn't really address bubbles ex ante; we would address them ex post. I think everybody's probably rethinking that a little bit. Bill Dudley recently at the BIS suggested maybe they're not that hard to identify.

I'm not quite sure where I stand on that. I think they're pretty hard. I just read a speech by the governor of the Bank of Japan, who said that even ex post they're hard to identify.

So there's a lot for us to think about, and there's a lot at stake. So we have to be careful, but we have to be we have to be -- also have to be very prudent with supervision.

BLINDER: If I could make a brief follow-up to that, the Treasury plan for financial reform would give the Fed significant systemic risk -- you can either call it regulated or monitored or whatever -- powers.

Do you see that as another tool that would make it easier to address bubbles -- even ex-ante, or certainly ex-post?

EVANS: So, I think that is another tool. When I was talking about better supervision, I wasn't being very specific, and it could include the systemic-risk regulator role.

The Fed has an umbrella supervision role already through the Gramm-Leach-Bliley, but not really enough authority, and so the additional legislation could be part of that. But whether it's the Fed or somebody else, what I think is very useful is the -- take to heart some of the lessons from our recent supervisory capital assessment program, or the stress test that we put 19 bank-holding companies through. We did a horizontal review with other regulators, and we looked very carefully at their portfolios and whether or not they had enough capital.

I think that horizontal type of review is the type of thing that a systemic-risk regulator would do with, potentially, a larger number of financial institutions, depending on how those are selected. And that would be a very important element to it. That, combined with appropriate conservative monetary policy positions to fight exuberant economic activity or inflationary pressures, I think that would be -- those are definitely elements in a good policy tool kit.

BLINDER: Way in the back there. The gentleman near the aisle.

QUESTIONER: Bill Drozdiak, American Council on Germany. My question relates to the cooperation with other central banks in the world. You mentioned the dual mandate of the Fed: maximum sustainable growth, and price stability. But other central banks, notably the European Central Bank, only focus on price stability. Has the latest financial crisis showed that this asymmetry has hampered cooperation? And do you think we would all benefit if the ECB and others adopted a dual mandate like the Fed?

EVANS: I don't think that the policy goals that each central bank have really been -- the different policy goals that each foreign central bank has been given, I don't think that that's been a source of friction for the current situation.

I think that there is often a lack of conflict between the price- stability goal and the maximum-sustainable-growth goal, because price stability helps support maximum sustainable growth. I think when the economies begin to contract, that puts downward pressure on inflation, so I think that, as I look at the actions taken by the ECB and the Bank of England and other central banks, they have also provided for more accommodative policy. I don't think that that's been a big issue.

I think that a lot of the discussions have been about the financial-stability role and the importance of our lending facilities and the fact that we've engaged in swap agreements with foreign central banks, between the U.S. and them, to allow for dollar liquidity overseas to help ease those pressures. I think we've had a pretty good set of discussions, and the actions that were -- needed to be taken have been taken.

BLINDER: There's a gentleman in the back corner. Work in the back, because that always gets ignored.

QUESTIONER: Thank you. Bal Das from Kailix Investment Advisers. Just going back to the question that Mr. Blinder asked, with the contemplated expansion in the role of the Federal Reserve, how do you think -- it seems to me that it's critically important for the Federal Reserve to be independent in order for it to fulfill its mandate of maximum sustainable growth and price stability. The expanded role -- how far do you think it is going to encroach on the fundamental independence of the Fed Reserve and drag it more into the legislative arena? Thank you.

EVANS: I know that it is a point of contention as to whether or not our supervisory role and the systemic-risk-regulator role would provide tension with our monetary-policy responsibilities. And, you know, different countries have organized these types of supervisory activities differently with the FSA and the Bank of England.

I think in the United States, we would be well served -- I think that from the Federal Reserve perspective, we get better monetary policy because of our supervisory activities, because we have a better understanding of financial institutions and the pressures they're facing and the strength of that and how they're providing credit to the economy, which is so important.

So I think we get a lot out of that. I think that the type of additional authority that's contemplated wouldn't necessarily change the scope of what we're doing that dramatically.

There's always tension between our actions and what they mean for financial institutions, if we're in a rising-rate environment or a lowering-rate environment, and what that means for the economy.

So the monetary policy arm of the Federal Reserve always has to be mindful of what's best for the economy. And I'm confident we would continue to do that.

But we would have to -- we would have to work through that and think about it pretty carefully. And I know that some of my colleagues have a number of thoughts on that.

BLINDER: A sidebar to that question: If you could, extend your answer to the sorts of quasi-fiscal operations that the Fed has been -- I think forced into is the right verb in the case of Bear Stearns, AIG and others. The same sort of issue has been raised about whether that imperils the Fed's independence.

EVANS: Right.

So during the current crisis, we've invoked the 13(3) authority where we've made loans to non-depository institutions. And that's a very unusual type of activity. It requires a super-majority vote of the board. And it does, you know, look a lot like fiscal policy types of action.

Certainly if you had a fiscal authority that could very quickly undertake these types of operations, then that would be the best way to organize those. And we certainly have assets on our balance sheet which would be better placed on the Treasury's balance sheet, because they're not typical central bank types of assets, with depository institutions.

I would -- you know, I would certainly welcome, you know, an alternative situation where under the new authority, we could have a rapid response, when appropriate, by the fiscal authority of the central bank, in conjunction with them. But you know, it's very complicated.

I'm hopeful -- this is sort of my response to the current supervisory and too-big-to-fail types of issues; which is, one of the lessons from this is that we don't really want to be in this place again. And so, we want to put in place policies which help us not need to invoke something like a 13-3 authority. And some of the suggestions that -- you know, this would also require the approval of the Treasury secretary. I -- you know, that seems like a fine suggestion, as well.

BLINDER: Thank you. Let me come back over here. The gentleman in the middle -- there, I think -- oh, lady. Is that Muriel?


BLINDER: I couldn't who's hand was up.

QUESTIONER: It's mine. Muriel Siebert, of Muriel Siebert and Company; former superintendent of banks for the state.

How did the subprime mess escape all of the regulatory procedures? Why didn't we catch it?

EVANS: That's a short question. I may not have a short answer. (Laughs, laughter.)

Yeah, that's a good question, obviously. So, you know, I think in part it has to do with the fragmented regulatory structure that we have, that there were a lot of mortgage brokers that were not supervised by federal entities, which we were not as well aware of in the Federal Reserve and other federal supervisors as perhaps we should have been. We were slow to appreciate that.

I think that we did recognize that there were products out there -- interest-only mortgages, things which didn't sound very good -- that we were somewhat slow to, you know, provide stern messages to banks and consumers about. So we could have done more with our rule- writing authority. I think we've learned some of those lessons.

I think that there was also a time, as recently as the spring of 2007, when Chairman Bernanke came to our bank-structure conference in Chicago and talked about the magnitude of the subprime dilemma. When we understood what the magnitude of those loans were and how they were not performing well and what the losses would be, we talked ourselves into thinking that this could be contained as a 50 (billion dollar) to $100 billion loss, and we failed to appreciate the amount of leverage that was embedded through collateralized debt obligations and other securitized products, which didn't have enough capital and skin in the game, frankly.

It is -- it is the case, unfortunately -- there are some nice research papers by Arvind Krishnamurthy and others at Northwestern University that talks about financial innovations and how when new products come out we often don't fully appreciate everything that's at stake there. And the history of this is that when the innovations first take place, there's a lot of exuberance, and then something not so good happens, and then we learn the safeguards that go with that. So hopefully, we will put in place the stronger safeguards for securitization markets, require more capital for financial institutions and avoid this.

But, you know, we didn't all do our jobs very well, and there's a lot of blame to go around everywhere.

BLINDER: Gentleman right here on the aisle.

QUESTIONER: Kim Davis from Charlesbank Capital. How would your speech differ if Congress were to pass either a 700-billion-(dollar) to a trillion-dollar health-care bill and/or the cap-and-trade? How would that impact your thinking on inflation expectations?

EVANS: Well, I think that, you know, sort of what's unstated in all of this is that there are potentially large, you know, liabilities through, you know, federal deficits. And you don't have to talk about the programs that you just mentioned; you can look at Medicare and Social Security, which are unfunded or not sufficiently funded into the indefinite future, and those are claims on future taxpayers, and how will we actually pay for that?

I'm, you know, pretty confident that Congress and the administration will sit down and start dealing with that. I thought that the most recent presidential election, it was pretty clear that, whoever won, this would be the administration that could no longer put off dealing with the entitlement programs, and they would have to be dealt with.

Now, since then, obviously, there's been a big mess with the financial situation, and deficits have grown, and we still have, you know, foreign wars that we're fighting. And so it's a big concern. And, you know, the deficits need to be dealt with. Pretty sure that, you know, the Fed and central banks will deal with this appropriately, but it's a big problem.

BLINDER: Yes. Howard.

QUESTIONER: Howard Berkowitz, BlackRock. Last night we were at a dinner where one -- a very well known economist stated that 60 percent of the new mortgages being written were being written by Ginnie Mae, and that the loan-to-value of those mortgages were 95 percent, and that the credit ratings were 620. That seems like we're getting -- going right back to where we were before, and I'd like to have your view on that.

EVANS: Well, I'm hopeful that mortgage underwriting will be better than it was in the past. (Laughter.) I just stated that I hope that we will have -- would have learned from some of those concerns.

And, you know, we'll certainly on the supervisory level be looking at, you know, the banks who ultimately are going to hold those assets or how they're going to be securitized. But, I mean, those are issues.

BLINDER: Last question right here. Front. She's coming right behind you.

QUESTIONER: John Brademas. I was a member of Congress for 22 years, and then I came here and found myself for a few years chairman of the Board of the New York Fed. So, against that background, what do you have to say, if anything, about the relationship between Congress and the Federal Reserve System?

EVANS: Well, I mean, you know, the Federal Reserve is accountable to the American people, to Congress. Congress oversees the Federal Reserve. Chairman Bernanke goes and testifies twice, regularly scheduled, to Congress, and any time Congress asks him to come up and opine or testify on particular issues, he always does it. Chairman Greenspan did that before.

So I think we are accountable to the American people. We are accountable to the American people. There's no doubt about that. I think that it's important for everybody involved to appreciate and have a central bank which is somewhat independent in the sense that they are able to take the tough actions which nobody else wants to take themselves. And, you know, so I think it's a process that works fairly well.

I know it's -- you know, I've learned to have a thicker skin in this business. I mean, I go out and talk to all kinds of people. I go to a luncheon; I sit next to a congressman who gives me an earful on his constituents. I listen to small-business people. I listen to my older brother, who's a small-business person, complain about how difficult it is to get bank loans or how those terms are adjusted.

I talk to people. I've got the state of Michigan in my territory, and they're suffering mightily. Their unemployment rate is 15 percent or more. I have a representative of the AFL-CIO from the state of Michigan on my Board of Directors, and so we hear regularly about the labor situation.

We go out and talk to a lot of people and everybody in an attempt to get the best information that we can to bring to Washington for our FOMC meetings. And that's the kind of information that Chairman Bernanke and other members of the Board of Governors go to Washington -- go to Capitol Hill and talk to Congress about.

So we try to be as open as we can be. And I think that's important.

BLINDER: You didn't say whether you like Congress or not. (Laughter.) But we won't push -- we won't push on that.

EVANS: I have a congressperson and two senators. I like them a lot. (Laughter.)

BLINDER: You didn't have to answer that.

Please join me in thanking Charles. (Applause.)

Thank you all very much.





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