The U.S. economy looks closer now to a turning point than it did just two months ago as the Federal Reserve's aggressive policies start to kick in more solidly, Chicago Federal Reserve Bank president Charles Evans said on Monday.
The Fed's array of non-standard measures will have to be reversed once the economy is more clearly headed toward sustainable growth and price stability, Evans said, without elaborating on when that time might arrive. His remarks were prepared for delivery to the Executives Club of Chicago.
Just as traditional policy is well known to act with long lags, nontraditional policies also take time to affect economic activity. So I expect to see further deterioration in some areas, notably job market conditions, before our policies gain full traction, Evans said.
At this point, weak economic news by itself would not imply that the Fed has misjudged its actions to end the recession, he said.
In my view, it would take a significant deterioration relative to our outlook for me to view our current policies as inadequate, Evans said. When finally measured, the downturn will likely match or surpass those of the 1970s and 1980s in depth and severity.
Evans is a voting member of the U.S. central bank's Federal Open Market Committee in 2009.
Among the building blocks for recovery are improving credit markets, Evans said, adding that financial market spreads have improved recently even as long Treasury market rates and mortgage rates have risen.
In contrast to some FOMC colleagues in recent weeks, Evans did not link rising Treasury yields to a risk that the pending U.S. economic recovery could be snuffed out, or address the reasons behind the jump in yields over the past month.
INFLATION CHAIN LINKS MISSING
Evans acknowledged worries about how the sharp run-up in the Fed's balance sheet could generate worries about inflation, given historical precedents, but said currently there is no middle link in a chain that has lead from credit expansion to inflation in the past.
Inflationary pressures will not arise without broader credit expansion, and there is no evidence for that at present. Nevertheless, these precedents explain why there is concern on this point and why we look after our ability to reverse the growth in our balance sheet, he said.
Evans said some of the Fed's various programs, especially those that provide back-up for short-term loans, will shrink naturally as market conditions improve. But he also said a significant portion of the balance sheet will likely not do so, which will force the central bank to develop what is likely to be a multi-pronged exit strategy.
We need tools to reduce it actively so that monetary policy can be easily recalibrated. In this respect, we can be as creative on the way out as we were on the way in.
Evans said forecasting the inflation outlook is especially difficult at the moment. Disinflationary pressures related to the recession have not been as severe as some had projected, but a wide output gap is still apparent, he said.
U.S. core consumer prices, which exclude food and energy, rose by 1.9 percent in the year through April. Figures for May, due on Wednesday, are projected to show a 1.8-percent advance. The overall CPI, however, was down 0.7 percent on the year through April.
A high unemployment rate and low rates of capacity usage, such as we now have, normally place strong downward pressure on costs and tend to lower inflation ... but inflation has not fallen to the extent we might have feared, said Evans.
Indeed, because some measures of inflation expectations didn't fall much during the recession, the risk is that as economic conditions improve, consumers and businesses might expect upward pressure on inflation, Evans warned.
Experience shows that a rise in inflation expectations, once solidified, becomes embedded in many economic decisions and makes inflation harder to control.
Core inflation near 2 percent would be acceptable under normal circumstances, Evans said, adding that forces of inflation could still pull in either direction.
(Editing by Chizu Nomiyama)