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Given that the subprime lending crisis has thrown uncertainties into the economic outlook, monetary policymakers need to consider some element of risk management to insure against future shocks to the economic system, said Charles Evans, president and CEO of the Federal Reserve Bank of Chicago.
“To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk-management considerations have an important role in the current policy environment,” Evans said in his first speech since becoming president of the Chicago Fed in September, at a Myron Scholes Global Markets Forum, which is part of the Initiative on Global Markets sponsored by Myron Scholes and the Chicago Council on Global Affairs, October 22 at Gleacher Center.
He said the Chicago Fed foresees “soft economic activity this fall” with a “further sharp decline” in residential housing investment depressing “top-line growth numbers.” But recovery is anticipated next year, with growth reaching “somewhat above 2.5 percent,” Evans said.
The housing market will continue to weaken because of “the continued high level of inventories of unsold homes” and “the cutback in nonconforming mortgage originations,” Evans said.
The effects may be “fairly isolated” to the housing market alone, with declines in residential construction.
On the other hand, “housing demand and prices could weaken a good deal more than we expect - either because a new shock hits the sector or because we have underestimated the weakness already in train,” Evans said. “A more pronounced downturn could weigh heavily on consumer spending.”
Additional delinquencies and foreclosures could further trouble mortgage-backed securities, adversely affecting financial conditions.
“Together such events would pose a more serious downside risk to growth,” Evans said. “I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high-cost outcomes that we should guard against.”
Policymakers must walk a fine line “in light of the lower probability” of such a scenario occurring and must be prepared to make corrections to ensure inflation is not affected if conditions improve and risks recede.
“With regard to inflation, we do not see any large movement one way or the other from current levels of core price inflation,” Evans said.
When questioned about the effect on unemployment and the potential loss of 25,000 jobs almost immediately because of the subprime lending crisis, Evans said the job loss was miniscule compared to the millions of jobs that fluctuate in and out quarterly and monthly in a “healthy and vibrant labor market.” The Fed must consider aggregate effects rather than individual sectors, such as housing, when figuring its fund rate, Evans said.
First-year student Guillermo Bravo, who said he found the speech “interesting” as he had never before been exposed to “this type of thinking, of reasoning,” was particularly interested in what Evans had said about the Fed taking into account more than just the housing market.
“Even though the [housing] market is a hot topic right now, they still have a very broad global view of everything,” Bravo said.
– Mary Sue Penn