In the midst of an internal debate over policy communication, Chicago Federal Reserve President Charles Evans pulled back on his 3 percent inflation threshold in a speech yesterday. Arguably, as the only policymaker suggesting guidance well above the Fed's stated 2 percent target, Evans was the last true dove at the Fed. With Evan's falling in line with his colleagues, it looks like the last sliver of hope that the Fed would tolerate slightly higher inflation to accelerate the reduction of real burden has now been dashed.
There is a lot of interesting material in Evan's speech, but here I focus only on his basic outlook and the implications for policy. Regarding growth:
That said, monetary policymakers must formulate policy for today. In the United States, forecasts by both private analysts and FOMC participants see real GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to move moderately higher in 2013, but only to a pace that is just somewhat above potential. Such growth would likely generate only a small decline in the unemployment rate.
Of course, he added earlier that this forecast is vulnerable to the possible of an austerity bomb in 2013, but for the moment assume that issue is resolved:
Having said all that, most forecasters are predicting that the pace of growth will pick up as we move through next year and into 2014. Underlying these projections is an assumption that fiscal disaster will be avoided—and with this, that some important uncertainties restraining growth should come off the table. Also, deleveraging will run its course, and as it does, the economy’s more-typical cyclical recovery dynamics will take over. As the FOMC indicated in its policy moves last September, the current highly accommodative stance for monetary policy will be kept in place for some time to come.
He then praises recent policy actions:
Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.
And then tackles a big question:
The natural question at this point is to ask: What constitutes substantial improvement in labor markets? Personally, I think we would need to see several things. The first would be increases in payrolls of at least 200,000 per month for a period of around six months. We also would need to see a faster pace of GDP growth than we have now — something noticeably above the economy’s potential rate of growth.
From Evan's perspective, these conditions would be sufficient to end the expansion of the balance sheet, although interest rates will remain near zero beyond that point. When should rates rise?
Of course, we will not maintain low rates indefinitely. For some time, I have advocated the use of specific, numerical thresholds to describe the economic conditions that would have to occur before it might be appropriate to begin raising rates.
On the employment mandate:
In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative....This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks.
So he shifts to a 6.5 percent threshold for unemployment, and later argues that even this might be a bit conservative as his models don't foresee much inflation pressure before 6 percent. See also Federal reserve Janet Yellen's recent speech; Evans' view is consistent with the optimal path forecasts. On one hand this is somewhat of a shift to the dovish side on the inflation forecast, suggesting that inflation will not accelerate as quickly as some might expect. What about the threshold for the rate of inflation itself?
With regard to the inflation safeguard, I have previously discussed how the 3 percent threshold is a symmetric and reasonable treatment of our 2 percent target. This is consistent with the usual fluctuations in inflation and the range of uncertainty over its forecasts. But I am aware that the 3 percent threshold makes many people anxious. The simulations I mentioned earlier suggest that setting a lower inflation safeguard is not likely to impinge too much on the policy stimulus generated by a 6-1/2 percent unemployment rate threshold. Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold before inflation begins to approach even a modest number like 2-1/2 percent.
So, given the recent policy actions and analyses I mentioned, I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Pride Index) inflation over the next two to three years, would be appropriate.
Notice that he really doesn't have a reason to shift his threshold; he doesn't even expect to hit the inflation threshold before hitting the employment threshold. His reason for essentially is that the 3 percent threshold makes people "anxious." Anxious about what? Anything that is perceived to be a threat to the Fed's credibility.
Does this shift on Evans' part really change anything? Probably not. He was always an outlier among Fed policymakers, with a tolerance for inflation as high as 3 percent making him a true dove. But he was never going to get any additional traction on that front from his colleagues. The 2 percent target is set in stone, and it is too much to expect the Fed will tolerate any meaningful deviations from that target. Of course, it is questionable that 3 percent is a meaningful deviation to begin with, but that is question is almost irrelevant at this point.
Bottom Line: By shifting his threshold on inflation, Evan's concedes to the political realities within the Fed. There was never much support for anything like tolerance for 3 percent inflation; for most policymakers, I suspect anything above 2.25 percent would be considered a threat to credibility. By falling in line with the rest of the FOMC, Evan abandons his role as a true dove, someone willing to tolerate substantially higher inflation. He is a dove now in the modern sense - a policymaker with a lower inflation forecast that allows for a longer period of easier policy.