A Discussion of the Fed's Dual Mandate Responsibilities

JEFFREY GARTEN: Good morning, everyone. It's my great pleasure to be the moderator for a session with Charles Evans, president of the Federal Reserve Bank of Chicago.

This meeting is part of the C. Peter McColough Series on International Economics. And before we start, could I ask everyone to please turn off their cellphones. Don't put it on vibrate, please; just turn it off altogether. I'd like to underline that this meeting is on the record, and also that tomorrow morning, there will be a meeting with former Treasury Secretary Hank Paulson.

Charles Evans' background is in the -- in the paper that you received when you came in this morning, so I'll only say a word. He has obviously had a very distinguished career, in large part at the Chicago Fed. And when you look at his background, you realize that he has arrived at his current position after a lot of very important positions, including the director of research. He's also taught at several prestigious universities.

I think we meet at a very interesting time, to say the least. The Fed has always played a central role in economic policy, but I don't think, at least in the time of everyone in this room, that there has been a period in which it has been more important and a period in which so much controversy has surrounded its actions in private and in public.

We've been through a major financial crisis. We're living through a very uncertain aftermath with big questions overhanging economic growth and financial regulation. We're seeing enormous intensification of the links, the financial and economic links among countries. We're seeing a ratcheting-up of political tensions around the Fed -- would have happened anyway, but in an election season, it's become acute, with perhaps significant implications for the independence of the Fed itself. And over and above all this, there are some very big issues relating to the tools that the Fed has, the tools that would be effective. Someone said that it's like a compass in a storm, and many people are not sure that compass is still reliable.

What we're going to do this morning is that Charles is going to give some opening remarks. He and I will then sit here and engage in a short discussion. And then at 8:30 we'll open the floor to questions, and we'll end at 9:00 sharp.

So Charles, if you'd like to say some words.

CHARLES EVANS: Jeffrey, thank you very much for that nice introduction.

It's a great honor to be here at such a prestigious organization and here to speak to this group. I had the benefit of being here about two years ago to come and speak, and so I'm honored to be back.

Today I would like to talk about the Federal Reserve's dual mandate. We've gotten a lot of attention. We've talked about it quite a lot. And you know, the Federal Reserve, in the Federal Reserve Act, is charged with maintaining monetary and financial conditions to support maximum employment and price stability. That's a little bit different than so many other central banks around the world, which place even more emphasis on price stability alone. And sometimes this approach is referred to as flexible inflation targeting. The chairman has talked about that. I'd like to give you my perspective on what that means. I think, in a way, that John Taylor from Stanford University could support, in the sense that he advocated exactly this back in 1979 in some pathbreaking research.

I'd like to talk a little bit about why this has led me to call for increasing amounts of policy accommodation, which is an unusual position, at least relative to the committee, and to also talk about why I think that this would be a prudent risk management approach to what we're facing in order to balance out some very disturbing potential risks that the economy is facing: on the one hand, risks that we repeat incidents like the 1930s or Japan over the last 15 years; or on the other side of the spectrum, risks that we report -- repeat the 1970s, with very high inflation. We'd like to avoid each of those potential outcomes. I'll try to explain to you why I think what I'm advocating would help out with that.

So I have some charts, which will be important here. And so if you could follow along. On Page 2, I've just got some charts, which summarize what I think -- summary statistics for our dual mandate. It's got the unemployment rate, and it's got the inflation rate. And when I was here two years ago, it was at a time when -- I believe it was September of 2009, and the Fed had taken strong action. We had committed to increasing the size of our balance sheet, and the monetary base was exploding.

And at that time I kind of had a similar type of discussion, in the sense that, on the one hand, we talked about how the Fed was trying to avoid the Great Depression 2.0, which we could have faced, given the tremendous downturn. That's why we stimulated through the creation of a large amount of money. That's what Milton Friedman said should have been done in the 1930s. But on the other hand, we could be facing the "great inflation 2.0," through repeating the '70s.

Well, two years later, inflation has remained relatively tame. I would say that the most recent increase in headline inflation was due to some relative price shocks -- energy, oil, commodity prices and food -- painful for everyone; not truly inflation that leads to a broad increase in all prices over an extended period of time. And if you just sort of look at this, the core inflation rates, you know, never got to be very problematic -- in fact, they weren't. And our forecast for headline inflation, the red dots, the FOMC central tendency forecasts continue to have us expecting below our inflation objective of 2 percent. So I would say that inflation pressures, while always risky, are somewhat muted.

On the other hand, we have the unemployment rate at 9 percent now, and it's only expected to decline very slowly. Just for instance, the forecast has in 2013 the unemployment rate still at 8 percent, which is very high. So now the question is: How do we think about this in a dual mandate context where you're supposed to think about employment as well -- and the real economy in general, and inflation -- how are we supposed to score this?

So on the next page, Page 3, I just have this setting for the current situation, where I compare the unemployment rate with inflation. And so currently, the red dot has, you know, the unemployment rate at 9 percent, and year-over-year core inflation at under 2 percent. And what you can see here is I've got the forecast of the FOMC into 2013, and I've got the forecast that we were putting forward in June and moving in an unfavorable direction towards the forecast that we put together in November. We had previously thought that at the end of 2013 the unemployment rate would be about 7-1/4 percent -- not very good -- to now, we think it's going to be 8 percent -- far worse.

On this chart, I have, you know, a guide towards how we should think about what our goals are. So inflation, our objective: I would say it's 2 percent for inflation. Ben Bernanke, our chairman, describes the longer-term forecast of the committee, which are 2 percent or just a little bit less. Some people are, you know, thinking 1-3/4 might be it, but let's say 2 percent; that's what the horizontal line is.

And then, we need to have some assessment of where the real economy could tend towards and rest at, an equilibrium unemployment rate which would not be associated with ever-rising inflation -- something that's sustainable. And we can talk at great length about this; happy to take questions on that. I would say, very conservatively, 6 percent would be one measure of that. We experienced in the last two recoveries unemployment well below that; rest point we thought was more like 5 percent. A 6-percent rate here allows for some structural difficulties that we have encountered here, so I think it's relatively conservative.

So now, how about the score card? If you flip to Chart 4 -- I was reading some commentary about my speeches recently, and they had said that: Evans is given to somehow vivid representations of what's going on. I gave a speech a few months ago where I tried to describe the dual mandate in terms that a conservative central banker anywhere ought to be able to understand, which is if you're going for 2 percent inflation and you find yourself at 5 percent with inflation, not only is it a catastrophe, but it's something that would make you feel as if your hair was on fire. (Laughter.) And that got picked up. (Laughter.)

And, you know, it was -- it was, you know, colorful language. But the idea is that if you're balancing out, you know, deviations of unemployment from where it ought to be -- and I would say here is -- in a very conservative sense, the 9-percent unemployment rate is every bit as unsatisfactory as the 5-percent inflation rate. So we ought to be behaving as if there's a very big problem out there. And to the extent that monetary policy could do anything more to improve upon this, that's what we ought to do.

So here I've taken -- now, this is ever so slightly technical. This is where the arithmetic would come into play, but this just graphically -- John Taylor (sp) in 1979 had a lovely, very technical research piece where he had a policy-maker who cared about unemployment -- actually, growth deviations and inflation deviations. He estimated it for the economy. And the most conservative estimates -- conservative in the sense that you care even more about inflation -- are the ones which are graphed here, sort of the circular assessments.

And so if we're doing our job right, we would be in the green area. That would be a very good outcome. That's the smiley, happy face, and that's green. And then as we get further away from that, it's yellow. And of course, the red is when you're really far away. So that's -- so that's sort of the situation. I would say it's not very good.

So chart five is simply trying to point out that from where we are, there are many better outcomes which would lead to less unemployment. And the inflation outcomes could go in either direction. They could either go lower or they could go higher. We'd like to go towards the origin here in the green. But anything moving leftward here within this range would be a clear improvement, as judged by the scorecard being inside of these circles moving towards the origin are preferred in a -- in a policy loss context. So these would be the favorable movements.

Of course, there are unfavorable movements, where we'd move further away from this unemployment, if something were to happen. We certainly want to avoid that.

So now the big question is, how do we get there? So I have suggested that, you know, currently the setting for monetary policy in our forward guidance from the FOMC we say that we can maintain extraordinarily low rates -- that means zero funds rates basically, 0.25 basis points. We used to say for an extended period of time -- I used to say that meant six months. We said that for 18 months, and then things began to be even worse than we were thinking. And so at our August meeting we introduced new language that said, you know, I think we could keep this in place until mid-2013, two years hence, assuming that economic conditions are the way that they are, which is with a lot of resource slack, and long-term inflation expectations are maintained.

But I think things have deteriorated since then. And as soon as we introduce calendar language, I think we need to provide some additional economic markers on that. So that's what I tried to do here.

So let me -- let me talk as briefly as I can about a risk management interpretation to this. To highlight the potential value of an alternative policy option, I want to focus on some risk management considerations related to our current economic problems.

Since the spring and summer of 2010, it's become more and more apparent that our macroeconomic problems are much larger than we had been planning for. There are essentially two storylines that are used to account for the abhorrently slow growth and high unemployment following the Great Recession.

The first storyline I want to refer to as the structural impediments scenario. In this scenario, the Great Recession was accompanied by an acute period of structural change. There was a tremendous amount of labor mismatch that came with that downturn. Uncertainty has been so large that it has potentially been killing job creation. And in fact, regulatory burdens have increased to the point where they're excessive.

As best I can tell, this scenario consists of a lot of conjectures about economic outcomes. But there isn't as much evidence from macroeconomic analysis of models that I'm accustomed to as a researcher, that comes from empirically relevant models. There just isn't that much, but there's a lot of conjectures, and it well could be true.

Nevertheless, in this storyline, the role for additional monetary accommodation is modest at best, and we are up against a supply constraint that monetary policy cannot fix. In this scenario, we would be guarding against a repeat of the 1970s. If this were the case, we should revert to business as usual monetary policies. Accordingly, it would be time to begin consider removing excess accommodation before inflation rises above target and inflation expectations become unhinged. That's one scenario.

Now, the second storyline I referred to is the liquidity trap scenario. In this scenario, short-term risk-free rates are zero, actual inflation-adjusted real rates are modestly negative, and the natural equilibrium real interest rate that the economy is striving for is strikingly negative. So we're not able to achieve as low a real interest rate as the economy wants in order to balance out savings and investment. This is due to an abundance of risk aversion, extreme patience and deleveraging, and these attitudes are unlikely to disappear anytime soon.

In this scenario, we're in the aftermath of an enormous Reinhart and Rogoff financial crisis, and the resulting drags on demand are exceedingly large and persistent. The clear and present danger here is that we repeat the experiences of the U.S. in the 1930s or Japan over the last 20 years.

Now, here there is actually a lot of economic modeling that has been simulated. And Gauti Eggertsson and Mike Woodford have done that, and Paul Krugman has talked about this, and others as well. The conclusions from this literature indicate that there are monetary policy prescriptions that can vastly improve outcomes in such an event.

Now, for me, I think the evidence strongly favors this liquidity trap scenario and not the structural impediment scenario. But ignoring that judgment, I want to focus on the risk management side of this. Rather than putting all of our policy eggs in one theoretical basket, let's consider the case where we don't know which scenario is really the one we face today. There's a debate. It's raging. This leads me to think more about a robust risk management approach to the dilemma that these two scenarios present. If both are possible but we don't know which one we face, how can we avoid risking a repeat of either the 1970s or the 1930s?

The problem is that policies that are optimal for the liquidity trap scenario would generate high inflation if the structural impediment scenario actually were true. Conversely, policies that are optimal for the structural impediment scenario -- do nothing -- would leave the economy mired in depression and deflation if applied during a liquidity trap scenario.

Now, fortunately, even amidst these extreme -- two extreme scenarios, there is a robust middle-ground policy approach. A relatively robust approach would be to sharpen our forward guidance in two directions: first, ensure accommodative policies as long as unemployment is somewhat above it's natural rate, that 6 percent level; but second, include an additional safeguard that accommodative policy will pull back if inflation rises above a threshold that would signal the economy is running into supply constraints such as those in the structural impediment scenario. In my opinion, the inflation safeguard threshold needs to be substantially above our 2 percent inflation objective, say 3 percent. And in the chart, you can see that I've got these -- proposed threshold where as long as inflation is below 3 percent, that's where policy would be accommodative.

Now, Professor Ken Rogoff at Harvard has been saying that maybe we should consider, you know, tolerating 4 percent inflation. And in fact, Governor Ben Bernanke, back when he was a governor, in 2003 suggested to Japan, when he was there, that perhaps they should consider a similarly large inflation objective temporarily in order to get over what they were facing at the time.

Now, this guidance for above-target inflation is consistent with the most recent liquidity trap research, which shows that improved economic performance during a liquidity trap requires allowing inflation to run higher than the inflation target for a time. Under this trigger threshold policy, if the liquidity trap scenario is indeed true, then the massive degree of resource slack in the economy means an output boom could be achieved without putting excessive pressure on productive resources, which are currently slack.

On the negative side, if the structural impediment scenario is instead true, inflation will rise more quickly and without any real side improvements. In such an adverse situation, the inflation safeguard triggers an exit from now-evident excessive policy accommodation. We would surely know that that scenario is in place as inflation began to rise towards the threshold, and we would withdraw that before inflation expectations became unhinged. Accordingly, under either scenario, this policy keeps long-term inflation expectations firm.

So in my opinion, applying this trigger-threshold risk management approach to our current economic situation is really just an embodiment of what I see as our broader flexible inflation targeting framework. It's simply the case that we're much, much further from where we should be, and that's why these policies seem so extraordinary. Normally, we wouldn't have to be working as hard as this. But I think that this would be useful, and that's the approach that I've been advocating.

So I will stop there, and we can have a further conversation.

GARTEN: Charles, thanks a million. I think we could spend the entire day talking about what you said. It's very clear and, I think, very, very thoughtful.

But just to open it up, let me just ask a few questions, and they're going to be of different orders of magnitude. But the first is, in the framework that you outlined, how do you respond to critics who would say that once there is even the specter that the Federal Reserve is willing to tolerate some inflation, it gets into the fabric of the economy; it gets into thought?

And so your approach is very (elegant/eloquent ?) but doesn't accord with how inflation actually becomes embedded. How do you deal with that? I would -- not to use his name in vain, but that would probably be the Paul Volcker approach.

EVANS: Well, I have a tremendous amount of respect for Paul Volcker. I had the great honor of hosting him for a luncheon in Chicago last fall when he spoke at our conference, and I got quite an earful about his attitudes towards inflation. He is a hero in the Federal Reserve system, and there's nobody who wants to give up on the gains that he painstakingly won for the U.S. economy and the Federal Reserve by fighting inflation.

I think that the current circumstances are really quite different than what we were facing in the '70s, and I think that it is possible, much like in the 1930s, central banks adhered so strongly to the gold standard, that we are simply facing, you know, the belief that we have to be, you know, extraordinarily conservative in our monetary policies to eradicate the ever-so-small risk that we would spark inflation.

I would say that things are dramatically different now than they were in the '70s. After all, we had a big increase in energy prices, commodity prices, food prices. Now the world economy's totally different. There are millions -- billions of people putting greater pressure on scarce resources, and there's just a new level that these prices are going to irrespective of what monetary policy is going to do.

If we were to try to fight that, we might have been able to alter that 25-percent increase in energy prices over six months so that in fact it was only 22 percent. That's the kind of thing that would have been necessary to bring down inflation.

But what's really different right now than the '70s is the '70s was a time where, on top of all of those issues that are present, policy was accommodative and every price was adjusting, and wages were adjusting. The cost of doing business was going up, labor was demanding that they keep up with this and stay on top of it, and wages -- it was a wage-cost-price spiral.

If there's anyone in this room who believes that wages are going to be going up, that labor is going to be able to command that keeping pace with those price pressures, I would like to hear much more about it because that is truly at the heart of what this inflation expectation scenario is.

But as I talk to business people, I hear a lot of careful planning, a lot of prudent business, decision-making, getting costs and workforces exactly right. But, you know, if we see more growth, there's going to be more hiring. There's no doubt about it. But if we don't see more growth, we're not going to get more hiring.

I worry about those things, but it's a little bit like being stranded on a desert island. You put up your shelter around the lagoon, you stay there, and you really don't know that on the other side of that hill there might be civilization and we can get out of this. Instead, you just stay nearby and you don't take those actions. I'd rather press it a little bit and find out.

The last 10 years going into December 2007, the average inflation rate was 2.7 percent. It's only recently that we've grown accustomed to thinking that we can achieve 2-percent inflation. The numbers that I'm talking about just aren't that big relative to the kinds of risks and fears that we saw in the 1970s. That was truly scary.

GARTEN: OK. Second question has to do with the dual mandate. We're all familiar with the dual mandate. My question is, where in that dual mandate do you put financial stability? One of the big issues that has arisen, obviously, in the last several years is that central banks missed -- they missed the financial crisis. They weren't focused on the right things when it comes to financial stability. And one of the -- I think at the heart of a lot of the Graham (sp)-Dodd legislation was that the Fed should be focused on financial stability. Is this a third mandate, or how do you accommodate that in your framework?

EVANS: Financial stability's unbelievably important, obviously. You know, financial intermediation, credit intermediation, that is an important ingredient in production that keeps the economy growing. And of course you would need to maintain, you know, the viability of that for a vibrant economy. So financial stability is very important.

And in fact, you know, the Federal Reserve Act -- sometimes the criticism of the dual mandate comes, well, you know, it also says that we should maintain moderate long-term interest rates, which is true. And, you know, financial stability is one way of maintaining moderation in interest rates. If you had, you know, a lot of instability, you would have a lot of risk premium, you'd have a lot of volatility in there. So I think there's clearly a role for focusing on financial stability.

The challenge for central bankers, of course, is that we really only have one -- maybe 1 1/2 instruments at our disposal. We move around short-term interest rates in order to induce stronger demand when things are weak or to choke off excessive demand when things are really growing strongly, maybe at a time when we've got, you know, the zero lower bound, then we bring in asset purchases. That's why I say maybe we got another half a tool. But in order to have three objectives, you can't hit three objectives with 1 1/2 tools or one tool.

So we need something else. And the answer has to be strong supervision, a strong culture of supervision, not excessive regulation but something which is focusing on excesses and imbalances which may be building up in the financial sector, recognizing that in a period where -- you know the criticism that the Fed policy, you know, from 2003 to 2006, where we had very low interest rates and that helped spur a bubble -- I don't think that's exactly right, but to the extent that there was some -- you know, some way in which we facilitated that, I don't think the answer was to raise interest rates at a time where the economy was not doing very well. It was a time to take stronger actions to maintain fiscal -- regulatory prudence by way of the supervisors.

And so Dodd-Frank tries to strike a balance. There's a lot of disagreement, obviously, but as a central bank we need to have an awareness of so much is going on in the fiscal system. Our regulatory authorities prior to Dodd-Frank limited some of our surveillance activities; now we have more of that. And we're ultimately -- even when we don't have the legal responsibility, ultimately at the end of the day everybody looks at us for why didn't you, you know, do more.

I was talking to somebody who said that we should have been regulating AIG, you know, when it's like we didn't really have that authority. And this was somebody who, if I showed up at their door and said I understand there's a rogue hedge fund somewhere in the building, I'm coming to look for it, they would not have looked on me very kindly. (Laughter.)

So we need to find the right balance. It's very difficult, but it's very important.

GARTEN: So this being the Council on Foreign Relations, let me ask you about the international dimension. When you sit around the table at FMOC (sic) and you look at, let's say, the last five years, how have the international implications, both for what the Fed does and also for what the Fed must consider -- how has that changed in the discussion that you and your colleagues have? Because certainly there is the sense in the air that coordination among central banks is going -- is and will continue to be one of the really big and very, very tough issues in the years ahead.

EVANS: Yeah, that's a tricky question, because we obviously have been spending quite a lot of time talking about the global economy, the global financial situation; and for much of that it was, you know, the response of, you know, foreign financial institutions and markets responding to what's going on in the U.S. after Lehman brothers and the financial distress. So what started here spread everywhere else, and then that had ramifications for those economies. And, you know, the dollar value actually went the wrong direction, right, from a lot of people's perspectives that thought we would weaken, but in fact we were a safe haven.

What's odd, though, is that in looking at the state of the economy in the U.S., the U.S. economy is so large that oftentimes we can get away with thinking about it almost as if it's a closed economy. We certainly talk about the international ramifications. A lot of times they sort of wash out in terms of net exports, and we've been running deficits for, you know, quite a long time. So we spend most of our time looking at domestic economic developments, but we're ever mindful of what's going on around the world. And at times like now, of course, you know, we redouble all of those efforts.

I keep thinking back to the late 1990s, during the Asian financial crisis and LTCM, and where, you know, foreign -- you know, Asian countries had a lot of difficulties, and how did we all get through this? Well, the American consumer was an engine of growth for the world economy, then and later. So we were sort of the safety valve for everybody.

Now, with what we're looking at, and if thing were, you know, to proceed unevenly, to say the least, around the world, the American consumer is not in a situation to perform that role anymore, and so I think it's much more challenging.

With the emergence of emerging markets in China, it would be, of course, a fabulous development if their consumer sector was stronger and played that role of a safety valve, but we're not anywhere near that now. So the risks are, you know, ever greater now. We spend a lot of time thinking about that.

GARTEN: And then the final question before we open this up. I think in the last year or two, there has been more transparency in terms of the various views in the Federal Reserve System. And I don't know whether it's just my imagination, but in the last year, a Martian who would come down would say this is a cacophony of voices with very, very different views -- not seeping out but actually being presented publicly.

I presume that this is deliberate, in the sense that Ben Bernanke wants it this way or is comfortable with this, but I'm interested from your standpoint, if you think about the markets and the way that they key on Federal Reserve decisions, how should we think about this range of very powerful views, some of them really on opposite ends of the spectrum? What is the -- what is the implication of a Federal Reserve where we have several people all advocating something that is different?

EVANS: It's a very interesting question. I'm sort of reminded of, you know, being at home with my personal computer and, you know, being dissatisfied with its performance and being reminded that, you know, with Microsoft Windows, you know, not everything is a bug, sometimes it's a feature. (Laughter.)

So, you know, Chairman Bernanke has brought to the committee a very good culture where we talk about everything extensively. Frankly, I think the committee under Chairman Greenspan, we did that too, but I think that everybody is even more comfortable in airing these viewpoints at the committee. You can look forward to reading the transcripts, you know, with a fire-year delay. Hopefully, you'll see the same thing.

But the idea is to, you know, bring the many different ways to look at the economy and how this works -- there are many trained economists -- and get the best thinking in order to solve the hardest problems. And, you know, as I think about the dual-mandate charts that I handed out here and sort of our operating procedure, you know, when we are close to our objectives, when we're not more than -- I mean, a percentage point away from your unemployment objective is actually quite large, but when you're within a percentage point, you know, on either side, business as usual, it really works to sort of say our objectives are maximum employment and price stability. But, you know, the way to achieve price stability, you know -- maximum employment is to achieve price stability.

It really is a case that most of the time by maintaining stable interest rates through stable inflation expectations and only moving, you know, policy around a little bit, we don't get in the way of a well-functioning economy and it does the best that it can and we get growth and we get employment and everything is fine.

But at the moment, things are so dramatically different than anything we have faced. I used to think that Paul Volcker in the -- '79-'82 was the most difficult policy situation that anybody an imagine since going back to the '30s. Well, I know that at least we're a close second to that. I think it's harder, even, and it was enormously difficult for him. In that environment it's just not -- I mean, you have to expect that there are going to be different viewpoints, people who think about it differently.

I tried to express as well as I could these very extreme views, structural impediments view versus a liquidity trap view. There's not a lot in the middle, and you have to come to grips with how you want to deal with that. So it's not surprising to me that as we go out -- and we try to be transparent and, you know, educate everyone about how we're thinking about it so that we can ultimately be accountable for doing the best job that we can.

I think that the chairman has done a good job in fostering debate and getting the best thinking on this, but it's challenging from the listening end. I'm sure of that. But, you know, the financial markets, you know, they have to -- you have to expend resources and figure these things out. That's just the way it goes.

GARTEN: OK, I'm going to open it up. I ask you to stand, please; state your affiliation. Remember this is on the record. And please, the more succinct the question, the better. And if you ask a question that's in three parts, I'm going to ask you only -- I'm going to ask him only to answer the first part, OK? One-part questions.

EVANS: Oh, I should get to choose, at least, which part I'm going to answer. (Laughter.)

GARTEN: OK, you can pick one of the parts.

QUESTIONER: Good morning. Joe Nadar (sp) with -- (inaudible). Thank you for your presentation, Charlie.

The question I have is, you give a proposal to try to deal with this uncertainty, and what I'd like to understand is, what's the debate internally and what's the criticism of the proposal? It sounds like a reasonable one to me.

EVANS: We put in place a large amount of accommodation, at least measured by the size of our balance sheet, at $2.8 trillion. So it's not an unreasonable view to think that we need to let that work its way through the economy. And on top of that, there are just a lot of things holding, you know, growth back that monetary policy can't address. That's not the view that I have.

And I would -- I'm certainly willing to push more accommodation into the system to sort of indicate here are the markers by which we will continue to have an accommodative policy, and on top of that I would say that we ought to describe what reasonable progress is towards that and then measure if we're making reasonable progress -- (inaudible). And if we're not making progress, then we should do more asset purchases, things like that.

Every action that we take is a non-standard one relative to what we've done in the -- you know, forever, pretty much, and so it's not surprising that people have an attitude that they'd like to go slow and be careful about that. And really that's the center of the consensus right now, is let's be careful, let's think about that. We've already done a lot. We've already done a lot, so let's be careful. And that's not unreasonable. I just found myself over a long period of time arguing for, you know, somewhat even more aggressive policy and finding myself sufficiently outside of that consensus that I thought I had to publicize that.

GARTEN: Yes, sir.

QUESTIONER: Maurice Tempelsman. Looking at it through the same refreshing lens of the realities of today rather than the past, what are your views on the continued role of the U.S. dollar as the reserve currency? And what are we doing to either maintain it or to really welcome the potential of changes that are taking place in the world, and how would it affect your room for maneuver internally?

EVANS: Yeah. I mean, the global economy is obviously evolving and the emerging markets are rising to new levels where they will, you know, be challenging, you know, the size and scale of, you know, the U.S. economy, European economies and around the world. So, you know, it would not be surprising if because of trade partners that there were a variety of so-called reserve currencies that were in, you know, wide use.

Now, having said that, the U.S. economy, even with all of our challenges, looks to be one of the strongest around the world, you know, at the moment. And, you know, there's a, you know, real debate and fight going on in Europe as to what their future will look like and what type of union they will have -- monetary, fiscal, how this will play out. And, you know, China, for all of its progress, is still rather opaque in terms of understanding how they will evolve and proceed as well.

And so it's just astounding to me that if, you know, you just take after the Lehman Brothers and the financial crisis in 2008, and you would have expected that, well, the dollar, with all of our difficulties, would have weakened dramatically, but in fact it's strengthened and we continue to have that safe-haven role. We have well-defined property rights. Our markets function as well or better than anybody else's. The problems that we're having, we're all confident that we will address and deal with so that we can continue to be competitive. I think it will play out however it plays out, but I think to the benefit of the U.S. and U.S. consumer and businesses, ultimately.

GARTEN: Rick.

QUESTIONER: I'm struck -- Richard Thoman, Corporate Perspectives at Columbia University. I'm struck by -- in your two scenarios, you didn't mention a word which I view as critical to how we get out of our problems, and that word is "leadership." We have a political system which our leadership probably is uniquely unable to deal with the private sector. Any progress in our economy will come through the private sector. And also in the last 10 years our CEO leadership -- and I'm a past CEO of a major company -- is much less public than it used to be for a whole series of reasons.

So we have a unique twin leadership deficit between our political system and our economic system that I don't know that we've ever had before. So I guess my question is could you talk a little bit about the role of leadership or the absence of leadership in either of your two -- or is it irrelevant, in your judgment?

EVANS: In the scenarios that I described, I did indeed tried to sidestep many of the issues that you were drawing attention to. And they are creating ever-greater impediments to what we're trying to achieve. I would say that the normal transmission of monetary policy is clogged by many difficulties that we are facing. In the mortgage market, we have taken sufficient actions that long-term interest rates have fallen by over a hundred basis points, and normally, we would have had a very, very large mortgage refinancing wave that would have put more disposable income into the hands of households who really need it either through wanting to save and pay down or through consumption, and that would generate growth, would generate employment, more income. That would be helpful.

So if we had stronger leadership that would tackle that and truly -- I mean, the proposals have been good. Glenn Hubbard at Columbia has had an excellent proposal there focusing on the risks that Fannie and Freddie already have, so why not make it better for everybody. If Congress and the administration could strike a good balance, you know, we'd all get up and applaud and be very happy about that. That's another impediment that is clogging up the situation. But everybody's got a job to do, and I'm just trying to do my own. (Laughter.)

GARTEN: Yes.

QUESTIONER: Hi, Tara Losenremer (ph). I'm with the council and also the New School here in New York. Just staying on the international for a moment and turning specifically to Europe, I wanted to know if you could just discuss a little bit your view on the role or the potential role of the European Central Bank in the fiasco that's currently unfolding.

EVANS: Yeah, so it's a challenging time to talk about these issues, obviously. I'm reminded that in the 20 years I've been in the Federal Reserve, you know, we used to take training on how not to answer questions about the dollar because that's the Treasury's problem. Going overseas to the ECB is even more challenging.

I think that, you know, the difficulties in Europe are remarkable, and the -- you know, the currency union that they've undertaken, I think, was a tremendous benefit to Europe. But it came with a tremendous obligation on the part of all of the countries involved, I think, which is that the countries that previously had used currency depreciation in order to get their way out of problems like this -- I mean, just think back to 1992. The U.K. and Italy were trying to benchmark against the Deutsche Mark. They couldn't do it. They depreciated dramatically, and their economies took off. That was one way out of that.

So countries that previously had paid high interest rates because of exchange rate risk now didn't face that risk, and so they had an opportunity to address the structural problems that their economies faced, increase the flexibility of their labor markets. All of the things that got in the way of their competitiveness on the real side, they had an opportunity to do at a relatively low cost. Unfortunately, human nature being what it is, those actions weren't taken, certainly not to scale, and now we have the problems that we have.

It is the case that in the United States, you know, a standard central bank plays a lender-of-last-resort role, you know, advancing credit against good collateral for short-term problems. Really, the problems that Europe has are longer-term purposes, and so the kind of lender-of-last-resort role that we're talking about is much more like fiscal policy. And a central banker is always going to remind everybody that fiscal policy needs to be dealt with by the fiscal authorities.

Central banking -- often the edges of that that bleed into fiscal policy are always unclear and gray at best, but we try to stay away from it. But Europe is clearly trying to avoid that. With 17 countries, you know, at stake with their own sovereignty, they've always shied away from that. So I think they have to deal with this in a fiscal sense, and we'll have to see how it progresses.

GARTEN: When you -- just building on this, obviously, that situation in Europe is very fragile, but when you look around the world and you look at the U.S. and you wake up in the morning, what's the thing that worries you the most? What's the worst thing that you can imagine, let's say, over the next three months?

EVANS: The worst thing is always the hardest part, right? I mean, you know, asteroids hitting, you know, Earth or -- (laughter) -- I -- there are many --

GARTEN: I'm going to ask you -- I'm going to ask -- (chuckles) -- let's stipulate that there won't be any -- (laughter) --

EVANS: So it's certainly the case -- so -- OK, it's certainly the case that Europe not being able to address the issues that they're facing, which leads to a very disorderly, you know, evolution in financial markets -- clearly, the world economy would be affected by that in the same way that the world economy cannot avoid the Lehman Brothers aftermath and AIG and everything that went on with that. This would be like that as well. So of course you're worried about waking up and discovering that that's the situation.

But on a more -- you know, something closer to what, you know, is within my job description, the thing that I worry about is waking up and everyone being complacent that things are just going to proceed OK, that we'll be able to muddle through, that we really don't need the actions; Congress might be able to continue to do what it's been doing forever for another couple of years, and things like that. I think that we're at the point where we do need leadership; we do need people to take strong actions. I have been, in a -- in a very small manner, trying to advance this by saying I think that we should be willing to, you know, accept slightly above-target inflation.

This is a very hard thing for a central banker to accept, let alone advocate. And when Paul Volcker -- you know, having had a conversation with Paul Volcker where, you know, I got the full, you know, spirit of his thoughts about what I'm saying -- (laughter) -- it's very hard to do. But I think that these are extraordinary times that require extraordinary actions, and we do need leadership.

GARTEN: OK.

Yes.

QUESTIONER: Andy Husar (ph), Morgan Stanley. How would you respond to claims that the tools in the Fed's toolkit are not effective to address the current situation given where excess reserves are already and that, really, what's required is fiscal stimulus rather than monetary stimulus?

EVANS: I understand those concerns, and it -- we'd all be better off if the actions that we had taken had had a bigger effect and it was clearly observable. I think that there are many impediments at work. One of them I've already mentioned, which is the mortgage market is clogged. Normally, what we would have done already would have had a much stronger effect and put real, disposal income in the hands of people who could use that. So that's a problem. So it would be good if some fiscal authority or the president or a regulator could go in and help address that. Then, I think, all of a sudden the actions that we've taken would be even more effective, and we'd begin to see that.

But I have spent some time going back and rereading Friedman and Schwartz's description of the 1930s, and it is remarkable the similarities in their accounts that a lot of actions were taken; they didn't always work out very well; you know, the gold standard was a limitation, and then all of a sudden you pulled back, and you convinced yourself that the action you'd taken couldn't do any more, and the complacency really kicked in. Businesspeople, you know, began to blame everybody else other than themselves for what was taking place, and nobody stepped up and did that. I mean, the parallels are just remarkable.

And I think in Japan -- you know, for the longest time we've all said, what's wrong with Japan. And the answer is, I don't know, but thank God it's not us. If I could feel more confident that what they have faced cannot come over here to the U.S., then I'm -- that might be all right. But I worry about that more and more.

So we have these tools. I think as you pump more and more liquidity into the system, eventually it starts to take hold. After all, we're trying to influence incentives. Incentives are what matter. And as long as people are comfortable holding on to cash, then you don't get more stimulus and investment, but if people start to see the opportunity cost of holding cash is not very good compared to investing in risky assets which would maintain their real value, that would begin to start something. And I really do believe that we're not so far away that if we begin to start something, then we might get the ball rolling and, you know, we'd really get momentum going.

GARTEN: Yes.

QUESTIONER: My name is Andrew Gundlach, Arnhold and S. Bleichroeder. Picking up on those exact words, I totally agree with you.

I think the distinction between the two policies might not be mutually exclusive. It could be both liquidity trap and a structural impediment. And to your point, the GDP numbers, if you would break them into long-lived assets and short-lived assets, the deficit is on the long-lived assets, which is obviously economic confidence.

But to your specific policy of higher inflation rates, one of the reasons the 3 trillion (dollars) of asset increase on the Fed's balance sheet has not worked is because the money multiplier is zero, which is a function of banks not knowing what their capital ratios are going to be and not having confidence, et cetera, et ceera. So just using --

GARTEN: Are you -- do you have a question?

QUESTIONER: Yeah. No, so just using your -- what you've done already, how do you get the money multiplier up without having to go to 3 percent?

EVANS: Well, I think we need -- I think we ultimately need -- you know, the way to get the monetary aggregates going, we've already got the base there, we need to see more lending, and so in fact we do need banks, you know, to start extending more loans.

Now, when I talk to bankers, it becomes very clear -- I don't question this -- that, you know, the demand for those loans is not exactly there. I mean, businesses have a lot of cash themselves, and they've been paying down debt and there's not a tremendous reason to expand, certainly not unnecessarily, and so, you know, that's why there's this chicken and the egg thing. I think if we could get things going a little bit, all of a sudden the lending environment would wake up and there'd be a lot of competition for those good -- there's already a lot of competition for the good loans. At the moment it's sort of cutting into market share. But if we could get some expansion going, I think that that would help.

And I think that in the -- you know, just to be careful, I think we should be willing to tolerate higher inflation. I'm not exactly advocating that we, you know, go for that inflation. And in the simulation analyses that I've seen, there's sufficient resource (slack ?). And if we are able to get the economy growing, then the potential of the economy would improve. And I don't think we actually would see those inflation rates. I think we might see 2 1/2 percent or something like that, but I don't think we would be seeing that.

But you're absolutely right. Things are gummed up at the moment, whether it's the mortgage market or demand for loans is down, and we need to somehow change the incentive so that people are more comfortable, you now, taking risk.

The capital issue, regulatory environment, that's clearly an issue, but these broader concerns about demand for loans being down, I hear that from a wide range of financial institutions, not just the ones who are in the, you know, more complicated markets where they have greater risks for their capital.

GARTEN: So I'm going to ask you the last question. What would you say to this: that, you know, the economy can go up or down, we could be in a recession or worse or we could come out of this, but if you were looking back 10 years, it's possible that the single biggest issue that we're facing is one without sharp edges, and that is the independence of the Fed. That the result of the Fed's activities in the financial crisis and the kind of debates that we're having now and the -- let's say the need for Fed activism and everything that that brings will eventually create a political situation -- and we see the beginnings of it at least -- that the political leaders will say too much power in an institution where people aren't elected, and that it will -- I think most people would have said that an independent Fed has been a wonderful feature of the American landscape, but that there is a growing risk that this will be eclipsed.

Do you guys talk about that at all in your -- you know, in your deliberations, do you worry about it, or am I talking about something that is too theoretical?

EVANS: You know, again, those are important issues. And, you know, in side conversations and as you're, you know, wondering in the middle of the night what kinds of things you might be facing, this is certainly one of them. It's important, for a central bank to be able to do its job, that it have a sufficient amount of distance between it and the political authorities so that we can take the tough actions that need to be taken.

I mean, one of the challenges for the politicians, democratically elected officials, they've got the key job, they're accountable to the public and we're accountable to them. And so, you know, Chairman Bernanke goes and testifies before Congress any time they like, but regularly, as well. That's the accountability. And it's just very important that we be able to take the hard actions.

Imagine, you know, if -- you know, Paul Volcker, doing the job that he did in '79, '82, allowing interest rates to go up to 18 percent on short-term interest rates, and if he had to go weekly to Congress and get their approval to do that, it wouldn't have happened. And Congress understands that, everybody -- you know, somebody's got to be the person who does that. I just want to make sure that at the end of the day, I get to call you in and, you know, criticize you and things like that. That's what comes with the job.

I understand that. Nobody likes it. The chairman has demonstrated unbelievable leadership in that regard. He took the actions in the aftermath of Lehman Brothers and AIG to provide, under 13.3 authority, additional assistance which was sorely needed. And, you know, everybody had to understand that you risk that Congress in the aftermath would go: 13/3? Wait a minute, I didn't know about that. I mean, that's a quote from an esteemed congressman. (Laughter.)

And, you know, so we are vested with a tremendous amount of power. We have to be accountable. And we are. And, you know, unfortunately, if you go back to the 1930s, they changed the -- you know, the Banking Act of 1935, you know, rearranged some authorities in the Federal Reserve, and, you know, hopefully it strengthened things. I think it did.

I just hope that once we get out of this, everybody will be focused on improving conditions and, you know, things will be a lot better. But that's a big concern because central banks have to be independent. The ECB is independent. You need accountability, all of these things. It's a real challenge.

But I think that Chairman Bernanke has demonstrated unbelievable leadership by taking those tough actions and, you know, worrying about the economy more than, you know, his own future and everything else. And I applaud him for that. Everything that I'm talking about here in terms of what I would like of policy, I do knowing that Chairman Bernanke ultimately will weigh in and make a very good decision. It may not be exactly the one that I think, but I think we're all pushing towards the same better outcomes.

GARTEN: Thank you very much.

EVANS: Thank you. (Applause.) Thank you, Jeffrey.

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THIS IS A RUSH TRANSCRIPT.

JEFFREY GARTEN: Good morning, everyone. It's my great pleasure to be the moderator for a session with Charles Evans, president of the Federal Reserve Bank of Chicago.

This meeting is part of the C. Peter McColough Series on International Economics. And before we start, could I ask everyone to please turn off their cellphones. Don't put it on vibrate, please; just turn it off altogether. I'd like to underline that this meeting is on the record, and also that tomorrow morning, there will be a meeting with former Treasury Secretary Hank Paulson.

Charles Evans' background is in the -- in the paper that you received when you came in this morning, so I'll only say a word. He has obviously had a very distinguished career, in large part at the Chicago Fed. And when you look at his background, you realize that he has arrived at his current position after a lot of very important positions, including the director of research. He's also taught at several prestigious universities.

I think we meet at a very interesting time, to say the least. The Fed has always played a central role in economic policy, but I don't think, at least in the time of everyone in this room, that there has been a period in which it has been more important and a period in which so much controversy has surrounded its actions in private and in public.

We've been through a major financial crisis. We're living through a very uncertain aftermath with big questions overhanging economic growth and financial regulation. We're seeing enormous intensification of the links, the financial and economic links among countries. We're seeing a ratcheting-up of political tensions around the Fed -- would have happened anyway, but in an election season, it's become acute, with perhaps significant implications for the independence of the Fed itself. And over and above all this, there are some very big issues relating to the tools that the Fed has, the tools that would be effective. Someone said that it's like a compass in a storm, and many people are not sure that compass is still reliable.

What we're going to do this morning is that Charles is going to give some opening remarks. He and I will then sit here and engage in a short discussion. And then at 8:30 we'll open the floor to questions, and we'll end at 9:00 sharp.

So Charles, if you'd like to say some words.

CHARLES EVANS: Jeffrey, thank you very much for that nice introduction.

It's a great honor to be here at such a prestigious organization and here to speak to this group. I had the benefit of being here about two years ago to come and speak, and so I'm honored to be back.

Today I would like to talk about the Federal Reserve's dual mandate. We've gotten a lot of attention. We've talked about it quite a lot. And you know, the Federal Reserve, in the Federal Reserve Act, is charged with maintaining monetary and financial conditions to support maximum employment and price stability. That's a little bit different than so many other central banks around the world, which place even more emphasis on price stability alone. And sometimes this approach is referred to as flexible inflation targeting. The chairman has talked about that. I'd like to give you my perspective on what that means. I think, in a way, that John Taylor from Stanford University could support, in the sense that he advocated exactly this back in 1979 in some pathbreaking research.

I'd like to talk a little bit about why this has led me to call for increasing amounts of policy accommodation, which is an unusual position, at least relative to the committee, and to also talk about why I think that this would be a prudent risk management approach to what we're facing in order to balance out some very disturbing potential risks that the economy is facing: on the one hand, risks that we repeat incidents like the 1930s or Japan over the last 15 years; or on the other side of the spectrum, risks that we report -- repeat the 1970s, with very high inflation. We'd like to avoid each of those potential outcomes. I'll try to explain to you why I think what I'm advocating would help out with that.

So I have some charts, which will be important here. And so if you could follow along. On Page 2, I've just got some charts, which summarize what I think -- summary statistics for our dual mandate. It's got the unemployment rate, and it's got the inflation rate. And when I was here two years ago, it was at a time when -- I believe it was September of 2009, and the Fed had taken strong action. We had committed to increasing the size of our balance sheet, and the monetary base was exploding.

And at that time I kind of had a similar type of discussion, in the sense that, on the one hand, we talked about how the Fed was trying to avoid the Great Depression 2.0, which we could have faced, given the tremendous downturn. That's why we stimulated through the creation of a large amount of money. That's what Milton Friedman said should have been done in the 1930s. But on the other hand, we could be facing the "great inflation 2.0," through repeating the '70s.

Well, two years later, inflation has remained relatively tame. I would say that the most recent increase in headline inflation was due to some relative price shocks -- energy, oil, commodity prices and food -- painful for everyone; not truly inflation that leads to a broad increase in all prices over an extended period of time. And if you just sort of look at this, the core inflation rates, you know, never got to be very problematic -- in fact, they weren't. And our forecast for headline inflation, the red dots, the FOMC central tendency forecasts continue to have us expecting below our inflation objective of 2 percent. So I would say that inflation pressures, while always risky, are somewhat muted.

On the other hand, we have the unemployment rate at 9 percent now, and it's only expected to decline very slowly. Just for instance, the forecast has in 2013 the unemployment rate still at 8 percent, which is very high. So now the question is: How do we think about this in a dual mandate context where you're supposed to think about employment as well -- and the real economy in general, and inflation -- how are we supposed to score this?

So on the next page, Page 3, I just have this setting for the current situation, where I compare the unemployment rate with inflation. And so currently, the red dot has, you know, the unemployment rate at 9 percent, and year-over-year core inflation at under 2 percent. And what you can see here is I've got the forecast of the FOMC into 2013, and I've got the forecast that we were putting forward in June and moving in an unfavorable direction towards the forecast that we put together in November. We had previously thought that at the end of 2013 the unemployment rate would be about 7-1/4 percent -- not very good -- to now, we think it's going to be 8 percent -- far worse.

On this chart, I have, you know, a guide towards how we should think about what our goals are. So inflation, our objective: I would say it's 2 percent for inflation. Ben Bernanke, our chairman, describes the longer-term forecast of the committee, which are 2 percent or just a little bit less. Some people are, you know, thinking 1-3/4 might be it, but let's say 2 percent; that's what the horizontal line is.

And then, we need to have some assessment of where the real economy could tend towards and rest at, an equilibrium unemployment rate which would not be associated with ever-rising inflation -- something that's sustainable. And we can talk at great length about this; happy to take questions on that. I would say, very conservatively, 6 percent would be one measure of that. We experienced in the last two recoveries unemployment well below that; rest point we thought was more like 5 percent. A 6-percent rate here allows for some structural difficulties that we have encountered here, so I think it's relatively conservative.

So now, how about the score card? If you flip to Chart 4 -- I was reading some commentary about my speeches recently, and they had said that: Evans is given to somehow vivid representations of what's going on. I gave a speech a few months ago where I tried to describe the dual mandate in terms that a conservative central banker anywhere ought to be able to understand, which is if you're going for 2 percent inflation and you find yourself at 5 percent with inflation, not only is it a catastrophe, but it's something that would make you feel as if your hair was on fire. (Laughter.) And that got picked up. (Laughter.)

And, you know, it was -- it was, you know, colorful language. But the idea is that if you're balancing out, you know, deviations of unemployment from where it ought to be -- and I would say here is -- in a very conservative sense, the 9-percent unemployment rate is every bit as unsatisfactory as the 5-percent inflation rate. So we ought to be behaving as if there's a very big problem out there. And to the extent that monetary policy could do anything more to improve upon this, that's what we ought to do.

So here I've taken -- now, this is ever so slightly technical. This is where the arithmetic would come into play, but this just graphically -- John Taylor (sp) in 1979 had a lovely, very technical research piece where he had a policy-maker who cared about unemployment -- actually, growth deviations and inflation deviations. He estimated it for the economy. And the most conservative estimates -- conservative in the sense that you care even more about inflation -- are the ones which are graphed here, sort of the circular assessments.

And so if we're doing our job right, we would be in the green area. That would be a very good outcome. That's the smiley, happy face, and that's green. And then as we get further away from that, it's yellow. And of course, the red is when you're really far away. So that's -- so that's sort of the situation. I would say it's not very good.

So chart five is simply trying to point out that from where we are, there are many better outcomes which would lead to less unemployment. And the inflation outcomes could go in either direction. They could either go lower or they could go higher. We'd like to go towards the origin here in the green. But anything moving leftward here within this range would be a clear improvement, as judged by the scorecard being inside of these circles moving towards the origin are preferred in a -- in a policy loss context. So these would be the favorable movements.

Of course, there are unfavorable movements, where we'd move further away from this unemployment, if something were to happen. We certainly want to avoid that.

So now the big question is, how do we get there? So I have suggested that, you know, currently the setting for monetary policy in our forward guidance from the FOMC we say that we can maintain extraordinarily low rates -- that means zero funds rates basically, 0.25 basis points. We used to say for an extended period of time -- I used to say that meant six months. We said that for 18 months, and then things began to be even worse than we were thinking. And so at our August meeting we introduced new language that said, you know, I think we could keep this in place until mid-2013, two years hence, assuming that economic conditions are the way that they are, which is with a lot of resource slack, and long-term inflation expectations are maintained.

But I think things have deteriorated since then. And as soon as we introduce calendar language, I think we need to provide some additional economic markers on that. So that's what I tried to do here.

So let me -- let me talk as briefly as I can about a risk management interpretation to this. To highlight the potential value of an alternative policy option, I want to focus on some risk management considerations related to our current economic problems.

Since the spring and summer of 2010, it's become more and more apparent that our macroeconomic problems are much larger than we had been planning for. There are essentially two storylines that are used to account for the abhorrently slow growth and high unemployment following the Great Recession.

The first storyline I want to refer to as the structural impediments scenario. In this scenario, the Great Recession was accompanied by an acute period of structural change. There was a tremendous amount of labor mismatch that came with that downturn. Uncertainty has been so large that it has potentially been killing job creation. And in fact, regulatory burdens have increased to the point where they're excessive.

As best I can tell, this scenario consists of a lot of conjectures about economic outcomes. But there isn't as much evidence from macroeconomic analysis of models that I'm accustomed to as a researcher, that comes from empirically relevant models. There just isn't that much, but there's a lot of conjectures, and it well could be true.

Nevertheless, in this storyline, the role for additional monetary accommodation is modest at best, and we are up against a supply constraint that monetary policy cannot fix. In this scenario, we would be guarding against a repeat of the 1970s. If this were the case, we should revert to business as usual monetary policies. Accordingly, it would be time to begin consider removing excess accommodation before inflation rises above target and inflation expectations become unhinged. That's one scenario.

Now, the second storyline I referred to is the liquidity trap scenario. In this scenario, short-term risk-free rates are zero, actual inflation-adjusted real rates are modestly negative, and the natural equilibrium real interest rate that the economy is striving for is strikingly negative. So we're not able to achieve as low a real interest rate as the economy wants in order to balance out savings and investment. This is due to an abundance of risk aversion, extreme patience and deleveraging, and these attitudes are unlikely to disappear anytime soon.

In this scenario, we're in the aftermath of an enormous Reinhart and Rogoff financial crisis, and the resulting drags on demand are exceedingly large and persistent. The clear and present danger here is that we repeat the experiences of the U.S. in the 1930s or Japan over the last 20 years.

Now, here there is actually a lot of economic modeling that has been simulated. And Gauti Eggertsson and Mike Woodford have done that, and Paul Krugman has talked about this, and others as well. The conclusions from this literature indicate that there are monetary policy prescriptions that can vastly improve outcomes in such an event.

Now, for me, I think the evidence strongly favors this liquidity trap scenario and not the structural impediment scenario. But ignoring that judgment, I want to focus on the risk management side of this. Rather than putting all of our policy eggs in one theoretical basket, let's consider the case where we don't know which scenario is really the one we face today. There's a debate. It's raging. This leads me to think more about a robust risk management approach to the dilemma that these two scenarios present. If both are possible but we don't know which one we face, how can we avoid risking a repeat of either the 1970s or the 1930s?

The problem is that policies that are optimal for the liquidity trap scenario would generate high inflation if the structural impediment scenario actually were true. Conversely, policies that are optimal for the structural impediment scenario -- do nothing -- would leave the economy mired in depression and deflation if applied during a liquidity trap scenario.

Now, fortunately, even amidst these extreme -- two extreme scenarios, there is a robust middle-ground policy approach. A relatively robust approach would be to sharpen our forward guidance in two directions: first, ensure accommodative policies as long as unemployment is somewhat above it's natural rate, that 6 percent level; but second, include an additional safeguard that accommodative policy will pull back if inflation rises above a threshold that would signal the economy is running into supply constraints such as those in the structural impediment scenario. In my opinion, the inflation safeguard threshold needs to be substantially above our 2 percent inflation objective, say 3 percent. And in the chart, you can see that I've got these -- proposed threshold where as long as inflation is below 3 percent, that's where policy would be accommodative.

Now, Professor Ken Rogoff at Harvard has been saying that maybe we should consider, you know, tolerating 4 percent inflation. And in fact, Governor Ben Bernanke, back when he was a governor, in 2003 suggested to Japan, when he was there, that perhaps they should consider a similarly large inflation objective temporarily in order to get over what they were facing at the time.

Now, this guidance for above-target inflation is consistent with the most recent liquidity trap research, which shows that improved economic performance during a liquidity trap requires allowing inflation to run higher than the inflation target for a time. Under this trigger threshold policy, if the liquidity trap scenario is indeed true, then the massive degree of resource slack in the economy means an output boom could be achieved without putting excessive pressure on productive resources, which are currently slack.

On the negative side, if the structural impediment scenario is instead true, inflation will rise more quickly and without any real side improvements. In such an adverse situation, the inflation safeguard triggers an exit from now-evident excessive policy accommodation. We would surely know that that scenario is in place as inflation began to rise towards the threshold, and we would withdraw that before inflation expectations became unhinged. Accordingly, under either scenario, this policy keeps long-term inflation expectations firm.

So in my opinion, applying this trigger-threshold risk management approach to our current economic situation is really just an embodiment of what I see as our broader flexible inflation targeting framework. It's simply the case that we're much, much further from where we should be, and that's why these policies seem so extraordinary. Normally, we wouldn't have to be working as hard as this. But I think that this would be useful, and that's the approach that I've been advocating.

So I will stop there, and we can have a further conversation.

GARTEN: Charles, thanks a million. I think we could spend the entire day talking about what you said. It's very clear and, I think, very, very thoughtful.

But just to open it up, let me just ask a few questions, and they're going to be of different orders of magnitude. But the first is, in the framework that you outlined, how do you respond to critics who would say that once there is even the specter that the Federal Reserve is willing to tolerate some inflation, it gets into the fabric of the economy; it gets into thought?

And so your approach is very (elegant/eloquent ?) but doesn't accord with how inflation actually becomes embedded. How do you deal with that? I would -- not to use his name in vain, but that would probably be the Paul Volcker approach.

EVANS: Well, I have a tremendous amount of respect for Paul Volcker. I had the great honor of hosting him for a luncheon in Chicago last fall when he spoke at our conference, and I got quite an earful about his attitudes towards inflation. He is a hero in the Federal Reserve system, and there's nobody who wants to give up on the gains that he painstakingly won for the U.S. economy and the Federal Reserve by fighting inflation.

I think that the current circumstances are really quite different than what we were facing in the '70s, and I think that it is possible, much like in the 1930s, central banks adhered so strongly to the gold standard, that we are simply facing, you know, the belief that we have to be, you know, extraordinarily conservative in our monetary policies to eradicate the ever-so-small risk that we would spark inflation.

I would say that things are dramatically different now than they were in the '70s. After all, we had a big increase in energy prices, commodity prices, food prices. Now the world economy's totally different. There are millions -- billions of people putting greater pressure on scarce resources, and there's just a new level that these prices are going to irrespective of what monetary policy is going to do.

If we were to try to fight that, we might have been able to alter that 25-percent increase in energy prices over six months so that in fact it was only 22 percent. That's the kind of thing that would have been necessary to bring down inflation.

But what's really different right now than the '70s is the '70s was a time where, on top of all of those issues that are present, policy was accommodative and every price was adjusting, and wages were adjusting. The cost of doing business was going up, labor was demanding that they keep up with this and stay on top of it, and wages -- it was a wage-cost-price spiral.

If there's anyone in this room who believes that wages are going to be going up, that labor is going to be able to command that keeping pace with those price pressures, I would like to hear much more about it because that is truly at the heart of what this inflation expectation scenario is.

But as I talk to business people, I hear a lot of careful planning, a lot of prudent business, decision-making, getting costs and workforces exactly right. But, you know, if we see more growth, there's going to be more hiring. There's no doubt about it. But if we don't see more growth, we're not going to get more hiring.

I worry about those things, but it's a little bit like being stranded on a desert island. You put up your shelter around the lagoon, you stay there, and you really don't know that on the other side of that hill there might be civilization and we can get out of this. Instead, you just stay nearby and you don't take those actions. I'd rather press it a little bit and find out.

The last 10 years going into December 2007, the average inflation rate was 2.7 percent. It's only recently that we've grown accustomed to thinking that we can achieve 2-percent inflation. The numbers that I'm talking about just aren't that big relative to the kinds of risks and fears that we saw in the 1970s. That was truly scary.

GARTEN: OK. Second question has to do with the dual mandate. We're all familiar with the dual mandate. My question is, where in that dual mandate do you put financial stability? One of the big issues that has arisen, obviously, in the last several years is that central banks missed -- they missed the financial crisis. They weren't focused on the right things when it comes to financial stability. And one of the -- I think at the heart of a lot of the Graham (sp)-Dodd legislation was that the Fed should be focused on financial stability. Is this a third mandate, or how do you accommodate that in your framework?

EVANS: Financial stability's unbelievably important, obviously. You know, financial intermediation, credit intermediation, that is an important ingredient in production that keeps the economy growing. And of course you would need to maintain, you know, the viability of that for a vibrant economy. So financial stability is very important.

And in fact, you know, the Federal Reserve Act -- sometimes the criticism of the dual mandate comes, well, you know, it also says that we should maintain moderate long-term interest rates, which is true. And, you know, financial stability is one way of maintaining moderation in interest rates. If you had, you know, a lot of instability, you would have a lot of risk premium, you'd have a lot of volatility in there. So I think there's clearly a role for focusing on financial stability.

The challenge for central bankers, of course, is that we really only have one -- maybe 1 1/2 instruments at our disposal. We move around short-term interest rates in order to induce stronger demand when things are weak or to choke off excessive demand when things are really growing strongly, maybe at a time when we've got, you know, the zero lower bound, then we bring in asset purchases. That's why I say maybe we got another half a tool. But in order to have three objectives, you can't hit three objectives with 1 1/2 tools or one tool.

So we need something else. And the answer has to be strong supervision, a strong culture of supervision, not excessive regulation but something which is focusing on excesses and imbalances which may be building up in the financial sector, recognizing that in a period where -- you know the criticism that the Fed policy, you know, from 2003 to 2006, where we had very low interest rates and that helped spur a bubble -- I don't think that's exactly right, but to the extent that there was some -- you know, some way in which we facilitated that, I don't think the answer was to raise interest rates at a time where the economy was not doing very well. It was a time to take stronger actions to maintain fiscal -- regulatory prudence by way of the supervisors.

And so Dodd-Frank tries to strike a balance. There's a lot of disagreement, obviously, but as a central bank we need to have an awareness of so much is going on in the fiscal system. Our regulatory authorities prior to Dodd-Frank limited some of our surveillance activities; now we have more of that. And we're ultimately -- even when we don't have the legal responsibility, ultimately at the end of the day everybody looks at us for why didn't you, you know, do more.

I was talking to somebody who said that we should have been regulating AIG, you know, when it's like we didn't really have that authority. And this was somebody who, if I showed up at their door and said I understand there's a rogue hedge fund somewhere in the building, I'm coming to look for it, they would not have looked on me very kindly. (Laughter.)

So we need to find the right balance. It's very difficult, but it's very important.

GARTEN: So this being the Council on Foreign Relations, let me ask you about the international dimension. When you sit around the table at FMOC (sic) and you look at, let's say, the last five years, how have the international implications, both for what the Fed does and also for what the Fed must consider -- how has that changed in the discussion that you and your colleagues have? Because certainly there is the sense in the air that coordination among central banks is going -- is and will continue to be one of the really big and very, very tough issues in the years ahead.

EVANS: Yeah, that's a tricky question, because we obviously have been spending quite a lot of time talking about the global economy, the global financial situation; and for much of that it was, you know, the response of, you know, foreign financial institutions and markets responding to what's going on in the U.S. after Lehman brothers and the financial distress. So what started here spread everywhere else, and then that had ramifications for those economies. And, you know, the dollar value actually went the wrong direction, right, from a lot of people's perspectives that thought we would weaken, but in fact we were a safe haven.

What's odd, though, is that in looking at the state of the economy in the U.S., the U.S. economy is so large that oftentimes we can get away with thinking about it almost as if it's a closed economy. We certainly talk about the international ramifications. A lot of times they sort of wash out in terms of net exports, and we've been running deficits for, you know, quite a long time. So we spend most of our time looking at domestic economic developments, but we're ever mindful of what's going on around the world. And at times like now, of course, you know, we redouble all of those efforts.

I keep thinking back to the late 1990s, during the Asian financial crisis and LTCM, and where, you know, foreign -- you know, Asian countries had a lot of difficulties, and how did we all get through this? Well, the American consumer was an engine of growth for the world economy, then and later. So we were sort of the safety valve for everybody.

Now, with what we're looking at, and if thing were, you know, to proceed unevenly, to say the least, around the world, the American consumer is not in a situation to perform that role anymore, and so I think it's much more challenging.

With the emergence of emerging markets in China, it would be, of course, a fabulous development if their consumer sector was stronger and played that role of a safety valve, but we're not anywhere near that now. So the risks are, you know, ever greater now. We spend a lot of time thinking about that.

GARTEN: And then the final question before we open this up. I think in the last year or two, there has been more transparency in terms of the various views in the Federal Reserve System. And I don't know whether it's just my imagination, but in the last year, a Martian who would come down would say this is a cacophony of voices with very, very different views -- not seeping out but actually being presented publicly.

I presume that this is deliberate, in the sense that Ben Bernanke wants it this way or is comfortable with this, but I'm interested from your standpoint, if you think about the markets and the way that they key on Federal Reserve decisions, how should we think about this range of very powerful views, some of them really on opposite ends of the spectrum? What is the -- what is the implication of a Federal Reserve where we have several people all advocating something that is different?

EVANS: It's a very interesting question. I'm sort of reminded of, you know, being at home with my personal computer and, you know, being dissatisfied with its performance and being reminded that, you know, with Microsoft Windows, you know, not everything is a bug, sometimes it's a feature. (Laughter.)

So, you know, Chairman Bernanke has brought to the committee a very good culture where we talk about everything extensively. Frankly, I think the committee under Chairman Greenspan, we did that too, but I think that everybody is even more comfortable in airing these viewpoints at the committee. You can look forward to reading the transcripts, you know, with a fire-year delay. Hopefully, you'll see the same thing.

But the idea is to, you know, bring the many different ways to look at the economy and how this works -- there are many trained economists -- and get the best thinking in order to solve the hardest problems. And, you know, as I think about the dual-mandate charts that I handed out here and sort of our operating procedure, you know, when we are close to our objectives, when we're not more than -- I mean, a percentage point away from your unemployment objective is actually quite large, but when you're within a percentage point, you know, on either side, business as usual, it really works to sort of say our objectives are maximum employment and price stability. But, you know, the way to achieve price stability, you know -- maximum employment is to achieve price stability.

It really is a case that most of the time by maintaining stable interest rates through stable inflation expectations and only moving, you know, policy around a little bit, we don't get in the way of a well-functioning economy and it does the best that it can and we get growth and we get employment and everything is fine.

But at the moment, things are so dramatically different than anything we have faced. I used to think that Paul Volcker in the -- '79-'82 was the most difficult policy situation that anybody an imagine since going back to the '30s. Well, I know that at least we're a close second to that. I think it's harder, even, and it was enormously difficult for him. In that environment it's just not -- I mean, you have to expect that there are going to be different viewpoints, people who think about it differently.

I tried to express as well as I could these very extreme views, structural impediments view versus a liquidity trap view. There's not a lot in the middle, and you have to come to grips with how you want to deal with that. So it's not surprising to me that as we go out -- and we try to be transparent and, you know, educate everyone about how we're thinking about it so that we can ultimately be accountable for doing the best job that we can.

I think that the chairman has done a good job in fostering debate and getting the best thinking on this, but it's challenging from the listening end. I'm sure of that. But, you know, the financial markets, you know, they have to -- you have to expend resources and figure these things out. That's just the way it goes.

GARTEN: OK, I'm going to open it up. I ask you to stand, please; state your affiliation. Remember this is on the record. And please, the more succinct the question, the better. And if you ask a question that's in three parts, I'm going to ask you only -- I'm going to ask him only to answer the first part, OK? One-part questions.

EVANS: Oh, I should get to choose, at least, which part I'm going to answer. (Laughter.)

GARTEN: OK, you can pick one of the parts.

QUESTIONER: Good morning. Joe Nadar (sp) with -- (inaudible). Thank you for your presentation, Charlie.

The question I have is, you give a proposal to try to deal with this uncertainty, and what I'd like to understand is, what's the debate internally and what's the criticism of the proposal? It sounds like a reasonable one to me.

EVANS: We put in place a large amount of accommodation, at least measured by the size of our balance sheet, at $2.8 trillion. So it's not an unreasonable view to think that we need to let that work its way through the economy. And on top of that, there are just a lot of things holding, you know, growth back that monetary policy can't address. That's not the view that I have.

And I would -- I'm certainly willing to push more accommodation into the system to sort of indicate here are the markers by which we will continue to have an accommodative policy, and on top of that I would say that we ought to describe what reasonable progress is towards that and then measure if we're making reasonable progress -- (inaudible). And if we're not making progress, then we should do more asset purchases, things like that.

Every action that we take is a non-standard one relative to what we've done in the -- you know, forever, pretty much, and so it's not surprising that people have an attitude that they'd like to go slow and be careful about that. And really that's the center of the consensus right now, is let's be careful, let's think about that. We've already done a lot. We've already done a lot, so let's be careful. And that's not unreasonable. I just found myself over a long period of time arguing for, you know, somewhat even more aggressive policy and finding myself sufficiently outside of that consensus that I thought I had to publicize that.

GARTEN: Yes, sir.

QUESTIONER: Maurice Tempelsman. Looking at it through the same refreshing lens of the realities of today rather than the past, what are your views on the continued role of the U.S. dollar as the reserve currency? And what are we doing to either maintain it or to really welcome the potential of changes that are taking place in the world, and how would it affect your room for maneuver internally?

EVANS: Yeah. I mean, the global economy is obviously evolving and the emerging markets are rising to new levels where they will, you know, be challenging, you know, the size and scale of, you know, the U.S. economy, European economies and around the world. So, you know, it would not be surprising if because of trade partners that there were a variety of so-called reserve currencies that were in, you know, wide use.

Now, having said that, the U.S. economy, even with all of our challenges, looks to be one of the strongest around the world, you know, at the moment. And, you know, there's a, you know, real debate and fight going on in Europe as to what their future will look like and what type of union they will have -- monetary, fiscal, how this will play out. And, you know, China, for all of its progress, is still rather opaque in terms of understanding how they will evolve and proceed as well.

And so it's just astounding to me that if, you know, you just take after the Lehman Brothers and the financial crisis in 2008, and you would have expected that, well, the dollar, with all of our difficulties, would have weakened dramatically, but in fact it's strengthened and we continue to have that safe-haven role. We have well-defined property rights. Our markets function as well or better than anybody else's. The problems that we're having, we're all confident that we will address and deal with so that we can continue to be competitive. I think it will play out however it plays out, but I think to the benefit of the U.S. and U.S. consumer and businesses, ultimately.

GARTEN: Rick.

QUESTIONER: I'm struck -- Richard Thoman, Corporate Perspectives at Columbia University. I'm struck by -- in your two scenarios, you didn't mention a word which I view as critical to how we get out of our problems, and that word is "leadership." We have a political system which our leadership probably is uniquely unable to deal with the private sector. Any progress in our economy will come through the private sector. And also in the last 10 years our CEO leadership -- and I'm a past CEO of a major company -- is much less public than it used to be for a whole series of reasons.

So we have a unique twin leadership deficit between our political system and our economic system that I don't know that we've ever had before. So I guess my question is could you talk a little bit about the role of leadership or the absence of leadership in either of your two -- or is it irrelevant, in your judgment?

EVANS: In the scenarios that I described, I did indeed tried to sidestep many of the issues that you were drawing attention to. And they are creating ever-greater impediments to what we're trying to achieve. I would say that the normal transmission of monetary policy is clogged by many difficulties that we are facing. In the mortgage market, we have taken sufficient actions that long-term interest rates have fallen by over a hundred basis points, and normally, we would have had a very, very large mortgage refinancing wave that would have put more disposable income into the hands of households who really need it either through wanting to save and pay down or through consumption, and that would generate growth, would generate employment, more income. That would be helpful.

So if we had stronger leadership that would tackle that and truly -- I mean, the proposals have been good. Glenn Hubbard at Columbia has had an excellent proposal there focusing on the risks that Fannie and Freddie already have, so why not make it better for everybody. If Congress and the administration could strike a good balance, you know, we'd all get up and applaud and be very happy about that. That's another impediment that is clogging up the situation. But everybody's got a job to do, and I'm just trying to do my own. (Laughter.)

GARTEN: Yes.

QUESTIONER: Hi, Tara Losenremer (ph). I'm with the council and also the New School here in New York. Just staying on the international for a moment and turning specifically to Europe, I wanted to know if you could just discuss a little bit your view on the role or the potential role of the European Central Bank in the fiasco that's currently unfolding.

EVANS: Yeah, so it's a challenging time to talk about these issues, obviously. I'm reminded that in the 20 years I've been in the Federal Reserve, you know, we used to take training on how not to answer questions about the dollar because that's the Treasury's problem. Going overseas to the ECB is even more challenging.

I think that, you know, the difficulties in Europe are remarkable, and the -- you know, the currency union that they've undertaken, I think, was a tremendous benefit to Europe. But it came with a tremendous obligation on the part of all of the countries involved, I think, which is that the countries that previously had used currency depreciation in order to get their way out of problems like this -- I mean, just think back to 1992. The U.K. and Italy were trying to benchmark against the Deutsche Mark. They couldn't do it. They depreciated dramatically, and their economies took off. That was one way out of that.

So countries that previously had paid high interest rates because of exchange rate risk now didn't face that risk, and so they had an opportunity to address the structural problems that their economies faced, increase the flexibility of their labor markets. All of the things that got in the way of their competitiveness on the real side, they had an opportunity to do at a relatively low cost. Unfortunately, human nature being what it is, those actions weren't taken, certainly not to scale, and now we have the problems that we have.

It is the case that in the United States, you know, a standard central bank plays a lender-of-last-resort role, you know, advancing credit against good collateral for short-term problems. Really, the problems that Europe has are longer-term purposes, and so the kind of lender-of-last-resort role that we're talking about is much more like fiscal policy. And a central banker is always going to remind everybody that fiscal policy needs to be dealt with by the fiscal authorities.

Central banking -- often the edges of that that bleed into fiscal policy are always unclear and gray at best, but we try to stay away from it. But Europe is clearly trying to avoid that. With 17 countries, you know, at stake with their own sovereignty, they've always shied away from that. So I think they have to deal with this in a fiscal sense, and we'll have to see how it progresses.

GARTEN: When you -- just building on this, obviously, that situation in Europe is very fragile, but when you look around the world and you look at the U.S. and you wake up in the morning, what's the thing that worries you the most? What's the worst thing that you can imagine, let's say, over the next three months?

EVANS: The worst thing is always the hardest part, right? I mean, you know, asteroids hitting, you know, Earth or -- (laughter) -- I -- there are many --

GARTEN: I'm going to ask you -- I'm going to ask -- (chuckles) -- let's stipulate that there won't be any -- (laughter) --

EVANS: So it's certainly the case -- so -- OK, it's certainly the case that Europe not being able to address the issues that they're facing, which leads to a very disorderly, you know, evolution in financial markets -- clearly, the world economy would be affected by that in the same way that the world economy cannot avoid the Lehman Brothers aftermath and AIG and everything that went on with that. This would be like that as well. So of course you're worried about waking up and discovering that that's the situation.

But on a more -- you know, something closer to what, you know, is within my job description, the thing that I worry about is waking up and everyone being complacent that things are just going to proceed OK, that we'll be able to muddle through, that we really don't need the actions; Congress might be able to continue to do what it's been doing forever for another couple of years, and things like that. I think that we're at the point where we do need leadership; we do need people to take strong actions. I have been, in a -- in a very small manner, trying to advance this by saying I think that we should be willing to, you know, accept slightly above-target inflation.

This is a very hard thing for a central banker to accept, let alone advocate. And when Paul Volcker -- you know, having had a conversation with Paul Volcker where, you know, I got the full, you know, spirit of his thoughts about what I'm saying -- (laughter) -- it's very hard to do. But I think that these are extraordinary times that require extraordinary actions, and we do need leadership.

GARTEN: OK.

Yes.

QUESTIONER: Andy Husar (ph), Morgan Stanley. How would you respond to claims that the tools in the Fed's toolkit are not effective to address the current situation given where excess reserves are already and that, really, what's required is fiscal stimulus rather than monetary stimulus?

EVANS: I understand those concerns, and it -- we'd all be better off if the actions that we had taken had had a bigger effect and it was clearly observable. I think that there are many impediments at work. One of them I've already mentioned, which is the mortgage market is clogged. Normally, what we would have done already would have had a much stronger effect and put real, disposal income in the hands of people who could use that. So that's a problem. So it would be good if some fiscal authority or the president or a regulator could go in and help address that. Then, I think, all of a sudden the actions that we've taken would be even more effective, and we'd begin to see that.

But I have spent some time going back and rereading Friedman and Schwartz's description of the 1930s, and it is remarkable the similarities in their accounts that a lot of actions were taken; they didn't always work out very well; you know, the gold standard was a limitation, and then all of a sudden you pulled back, and you convinced yourself that the action you'd taken couldn't do any more, and the complacency really kicked in. Businesspeople, you know, began to blame everybody else other than themselves for what was taking place, and nobody stepped up and did that. I mean, the parallels are just remarkable.

And I think in Japan -- you know, for the longest time we've all said, what's wrong with Japan. And the answer is, I don't know, but thank God it's not us. If I could feel more confident that what they have faced cannot come over here to the U.S., then I'm -- that might be all right. But I worry about that more and more.

So we have these tools. I think as you pump more and more liquidity into the system, eventually it starts to take hold. After all, we're trying to influence incentives. Incentives are what matter. And as long as people are comfortable holding on to cash, then you don't get more stimulus and investment, but if people start to see the opportunity cost of holding cash is not very good compared to investing in risky assets which would maintain their real value, that would begin to start something. And I really do believe that we're not so far away that if we begin to start something, then we might get the ball rolling and, you know, we'd really get momentum going.

GARTEN: Yes.

QUESTIONER: My name is Andrew Gundlach, Arnhold and S. Bleichroeder. Picking up on those exact words, I totally agree with you.

I think the distinction between the two policies might not be mutually exclusive. It could be both liquidity trap and a structural impediment. And to your point, the GDP numbers, if you would break them into long-lived assets and short-lived assets, the deficit is on the long-lived assets, which is obviously economic confidence.

But to your specific policy of higher inflation rates, one of the reasons the 3 trillion (dollars) of asset increase on the Fed's balance sheet has not worked is because the money multiplier is zero, which is a function of banks not knowing what their capital ratios are going to be and not having confidence, et cetera, et ceera. So just using --

GARTEN: Are you -- do you have a question?

QUESTIONER: Yeah. No, so just using your -- what you've done already, how do you get the money multiplier up without having to go to 3 percent?

EVANS: Well, I think we need -- I think we ultimately need -- you know, the way to get the monetary aggregates going, we've already got the base there, we need to see more lending, and so in fact we do need banks, you know, to start extending more loans.

Now, when I talk to bankers, it becomes very clear -- I don't question this -- that, you know, the demand for those loans is not exactly there. I mean, businesses have a lot of cash themselves, and they've been paying down debt and there's not a tremendous reason to expand, certainly not unnecessarily, and so, you know, that's why there's this chicken and the egg thing. I think if we could get things going a little bit, all of a sudden the lending environment would wake up and there'd be a lot of competition for those good -- there's already a lot of competition for the good loans. At the moment it's sort of cutting into market share. But if we could get some expansion going, I think that that would help.

And I think that in the -- you know, just to be careful, I think we should be willing to tolerate higher inflation. I'm not exactly advocating that we, you know, go for that inflation. And in the simulation analyses that I've seen, there's sufficient resource (slack ?). And if we are able to get the economy growing, then the potential of the economy would improve. And I don't think we actually would see those inflation rates. I think we might see 2 1/2 percent or something like that, but I don't think we would be seeing that.

But you're absolutely right. Things are gummed up at the moment, whether it's the mortgage market or demand for loans is down, and we need to somehow change the incentive so that people are more comfortable, you now, taking risk.

The capital issue, regulatory environment, that's clearly an issue, but these broader concerns about demand for loans being down, I hear that from a wide range of financial institutions, not just the ones who are in the, you know, more complicated markets where they have greater risks for their capital.

GARTEN: So I'm going to ask you the last question. What would you say to this: that, you know, the economy can go up or down, we could be in a recession or worse or we could come out of this, but if you were looking back 10 years, it's possible that the single biggest issue that we're facing is one without sharp edges, and that is the independence of the Fed. That the result of the Fed's activities in the financial crisis and the kind of debates that we're having now and the -- let's say the need for Fed activism and everything that that brings will eventually create a political situation -- and we see the beginnings of it at least -- that the political leaders will say too much power in an institution where people aren't elected, and that it will -- I think most people would have said that an independent Fed has been a wonderful feature of the American landscape, but that there is a growing risk that this will be eclipsed.

Do you guys talk about that at all in your -- you know, in your deliberations, do you worry about it, or am I talking about something that is too theoretical?

EVANS: You know, again, those are important issues. And, you know, in side conversations and as you're, you know, wondering in the middle of the night what kinds of things you might be facing, this is certainly one of them. It's important, for a central bank to be able to do its job, that it have a sufficient amount of distance between it and the political authorities so that we can take the tough actions that need to be taken.

I mean, one of the challenges for the politicians, democratically elected officials, they've got the key job, they're accountable to the public and we're accountable to them. And so, you know, Chairman Bernanke goes and testifies before Congress any time they like, but regularly, as well. That's the accountability. And it's just very important that we be able to take the hard actions.

Imagine, you know, if -- you know, Paul Volcker, doing the job that he did in '79, '82, allowing interest rates to go up to 18 percent on short-term interest rates, and if he had to go weekly to Congress and get their approval to do that, it wouldn't have happened. And Congress understands that, everybody -- you know, somebody's got to be the person who does that. I just want to make sure that at the end of the day, I get to call you in and, you know, criticize you and things like that. That's what comes with the job.

I understand that. Nobody likes it. The chairman has demonstrated unbelievable leadership in that regard. He took the actions in the aftermath of Lehman Brothers and AIG to provide, under 13.3 authority, additional assistance which was sorely needed. And, you know, everybody had to understand that you risk that Congress in the aftermath would go: 13/3? Wait a minute, I didn't know about that. I mean, that's a quote from an esteemed congressman. (Laughter.)

And, you know, so we are vested with a tremendous amount of power. We have to be accountable. And we are. And, you know, unfortunately, if you go back to the 1930s, they changed the -- you know, the Banking Act of 1935, you know, rearranged some authorities in the Federal Reserve, and, you know, hopefully it strengthened things. I think it did.

I just hope that once we get out of this, everybody will be focused on improving conditions and, you know, things will be a lot better. But that's a big concern because central banks have to be independent. The ECB is independent. You need accountability, all of these things. It's a real challenge.

But I think that Chairman Bernanke has demonstrated unbelievable leadership by taking those tough actions and, you know, worrying about the economy more than, you know, his own future and everything else. And I applaud him for that. Everything that I'm talking about here in terms of what I would like of policy, I do knowing that Chairman Bernanke ultimately will weigh in and make a very good decision. It may not be exactly the one that I think, but I think we're all pushing towards the same better outcomes.

GARTEN: Thank you very much.

EVANS: Thank you. (Applause.) Thank you, Jeffrey.

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