I find it helpful to summarize the relevant information in what I term a mandate dashboard. Here’s what the dashboard looked like in the FOMC meeting earlier this month.

Large Image

I’ll explain the dashboard starting with the inflation side. The first cell from the left is current inflation. The second cell is what inflation is projected to be in one year’s time. Finally, the third cell contains a forecast for inflation in two years’ time. The unemployment side is similar. The first cell from the left is current unemployment. The second cell contains a forecast for unemployment in one year’s time, and the third cell is a forecast for unemployment in two years’ time. The various forecasts are based on the Summary of Economic Projections released by the FOMC earlier this month.

It is important to note that the dashboard includes information from other current variables besides inflation and unemployment. The forecasts for inflation and unemployment could potentially be based on a wide range of information—anticipated changes in fiscal policy, changes in European financial markets and so on. So, basing policy on the mandate dashboard does allow policy to react to changes in these other economic variables. However, using this kind of dashboard does require monetary policy to respond to any economic variable only insofar as that variable affects current and future inflation or unemployment. This restriction seems appropriate given the limited nature of the FOMC’s statutory assignment from Congress.

Given this mandate dashboard, how should the level of monetary accommodation evolve over time in response to changes in the dashboard’s readings? In general, the answer to this question is subtle, because it depends on how the FOMC weights its two mandates. However, there are two common cases in which the mandate dashboard becomes straightforward to use. Suppose current and expected inflation rise and current and expected unemployment fall, as is often true in a recovery. Then, regardless of how it weights its two mandates, the FOMC should reduce the level of accommodation. Alternatively, suppose inflation and expected inflation go down and unemployment and expected unemployment go up, as is often true when the economy slows. Then, regardless of how it weights its two mandates, the FOMC should increase the level of accommodation.

A public contingency plan for 2012 would specify how the FOMC would act in a number of scenarios for the mandate dashboard in a year’s time. It’s useful to start with the FOMC’s projected scenario for 2012.

Large Image

Notice that the second cell for the November 2012 row is the forecast for inflation over the course of 2013, and the second cell for the November 2011 row is the forecast for inflation over the course of 2012. We generally think that monetary policy operates with a one- or two-year lag. Accordingly, the dashboard keeps track of what we expect the economy to be like in a year or two.

If we compare the second row with the first, we see that in this scenario, core inflation is about the same in a year’s time as it is now. Unemployment is lower. These changes imply that the Committee should reduce the level of monetary accommodation over the coming year. But, like those of many private sector forecasters, the FOMC’s projections have proven imperfect over the past few years. With that in mind, the Committee should provide guidance to the public about how it will respond to unexpected changes in the mandate dashboard. Suppose, for example, that the following alternative scenario occurs in 2012, in which economic conditions are worse than expected:

Large Image

In this alternative scenario, inflation has fallen since November 2011 and unemployment has risen since November 2011. Here the Committee should increase the level of accommodation relative to November 2011.

In this way, a public contingency plan would allow people to better predict how the Committee plans to react to a variety of economic scenarios. In a speech given in May 2010, Chairman Bernanke stated, “Transparency regarding monetary policy … not only helps make central banks more accountable, it also increases the effectiveness of policy.”¹ I agree completely with this sentiment. And I see a public contingency plan, based on the explicit use of metrics like the mandate dashboard, as promoting exactly the kind of transparency that Chairman Bernanke was describing. Thank you.

Making Monetary Policy: Public Contingency Planning Using a Mandate Dashboard - Full Speech

Endnotes

John, thanks for the introduction and for the invitation to be here today. It’s great to be back on the Farm. I have to say that there have been lots of changes. I’ve been away only six years, but I hardly recognize the place. This building is, in particular, a fantastic addition to the economics scene here on campus.

In my remarks today, I’d like to touch on several topics. I’ll begin with a quick description of the structure of the Federal Reserve System and the deliberative process of the Federal Open Market Committee—the Committee that makes monetary policy for the nation. Then I’ll describe the FOMC’s objectives. Next, I’ll discuss how the FOMC can enhance the pursuit of its objectives by formulating a public contingency plan, based on what I term a “mandate dashboard.” Finally, I’ll close with a discussion of considerations for near-term monetary policy actions.

After that, I’ll be pleased to answer any questions you may have. And before I begin, I should remind you that my comments here today reflect my views alone and not necessarily those of others in the Federal Reserve System, including my FOMC colleagues.

Some FOMC Basics

Let me begin with some basics about the Federal Reserve System. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and by area, we’re the second largest. Our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the FOMC meets to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Currently, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually. Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas and Chicago Federal Reserve Banks.

I’ve said that the FOMC meets (at least) eight times per year. But how do these meetings work? At a typical meeting, there are two so-called go-rounds, in which every president and every governor has the opportunity to speak without interruption. The first of these is referred to as the economics go-round. It is kicked off by a presentation on current economic conditions by Federal Reserve staff economists. Then the presidents and governors describe their individual views on current economic conditions and their respective outlooks for future economic conditions. The presidents typically start by providing information about their district’s local economic performance. We get that information from our research staffs, but also from our interactions with business and community leaders in industries and towns from across our districts.

The Committee next turns to the second go-round, which focuses on policy. Again, the staff begins, with a presentation of policy options. After that, each of the 17 meeting participants has a chance to speak on what each views as the appropriate policy choice. This set of remarks is followed with a summary by the chairman, in which he lays out what he sees as the Committee’s consensus view for future policy. The voting members of the FOMC then cast their votes on this policy statement and thereby set monetary policy for the next six to seven weeks.

My description of an FOMC meeting highlights how the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. And, as I’ve described, their input relies critically on information received from district residents. In this way, the Federal Reserve System is deliberately designed to give the residents of Main Street a voice in national monetary policy.

FOMC Objectives

I’ve said that FOMC participants seek to adopt what they view as the appropriate policy choice. That provides a natural segue into my next topic: the policy objectives of the FOMC. The FOMC has a dual mandate, established by Congress: to set monetary policy so as to promote price stability and maximum employment. The heart of the price stability mandate is the Federal Reserve’s inflation objective. The FOMC communicates its inflation objective to the public in a number of ways. Most prominently, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation in the longer run (maybe five or six years), assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.”

Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. An important and ongoing communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. Changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.”

It is important to keep in mind that these changes in maximum employment can be short run or long run in nature. Like the rest of my colleagues on the FOMC, I expect unemployment to normalize at 5 percent or 6 percent in the longer run under optimal monetary policy. But I want to stress that that estimate of long-run unemployment does not reflect my assessment of the current level of “maximum employment.”

Over the past year, the FOMC has communicated through its statements that it perceives the current unemployment rate to be elevated relative to levels that it views as consistent with its dual mandate. In this situation, there is a trade-off involved in the making of monetary policy. On the one hand, adding monetary accommodation reduces unemployment, other things equal. On the other hand, adding accommodation increases the risk of generating inflation markedly higher than the Committee’s objective of 2 percent for a significant period of time. In choosing whether to add monetary stimulus or not, the Committee must resolve this trade-off between reducing unemployment and increasing the risk of inflation.

Public Contingency Planning Based on a Mandate Dashboard

I’ve described how an FOMC meeting works, the FOMC’s objectives and the tensions that currently exist between those objectives. I now want to turn to the formation of policy designed to achieve the FOMC’s objectives.

Right now, the FOMC has two types of accommodation in place. First, it is targeting a short-term interest rate, the federal funds rate, between 0 and 0.25 percent, and it plans to keep that interest rate that low at least through mid-2013—that is, for at least the next six to seven quarters. This low interest rate is intended to stimulate consumption by households and investment by firms.

Second, the FOMC has bought a large amount of long-term government-issued and government-backed assets. These asset holdings are designed to stimulate longer-term investment. More specifically, any holder of a long-term bond is exposed to interest rate risk, because the value of that bond fluctuates as interest rates vary. When the Fed buys long-term bonds from the private sector, the private sector as a whole is exposed to less interest rate risk. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk. Consequently, all long-term yields fall—and corporations should correspondingly lower their hurdle rates for long-term investment projects.

The FOMC does have additional tools. It could exert further downward pressure on long-term market interest rates by buying more long-term Treasury securities or securities issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. Alternatively, the Committee could extend its prediction for how long it will keep its target short-term interest rate exceptionally low. So, tools—and choices—remain.

However, I believe that the FOMC should do more than simply decide at each meeting whether or not to buy more assets or to keep interest rates low for longer. Any current decision is based on the FOMC’s forecast for the future, and no forecast can be perfect. The Committee should provide a public contingency plan—that is, provide guidance on how it will respond to a variety of relevant scenarios. I believe that public contingency planning would have many benefits. Let me mention two.

First, without appropriate context, the FOMC’s actions may at times suggest that its formulation of its dual mandate objectives has changed. For example, I’ve spoken to many members of the public who believe that the FOMC’s current highly accommodative policies imply that the FOMC’s inflation objective has shifted upward. I’ve certainly argued that they’re wrong. But I’m sure that, by articulating a clear public contingency plan and sticking to it, the FOMC can inspire greater public confidence that FOMC actions represent the systematic pursuit of its dual mandate objectives.

Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. An FOMC public contingency plan can help reduce the contribution of monetary policy to this general background of uncertainty. But how should the FOMC formulate this public contingency plan? I believe that it is useful to think of a driver who is trying to maintain a car speed. To do so, he’ll vary pressure on the accelerator in response to changes in road conditions, current and expected: hills, valleys, rough pavement, headwinds. In the same way, the FOMC varies its chosen level of monetary accommodation in response to changes in current and expected economic conditions.

This kind of systematic response to changing economic conditions strikes me as an essential part of good monetary policy for at least two reasons. First, there is a great deal of empirical evidence and theoretical support for the idea that following a policy rule, as economists call it, is what enables the Committee to achieve its dual mandate goals. Second, and perhaps more importantly, actions speak louder than words. The Committee can claim that it intends to make monetary policy so as to fulfill its dual mandate. But the public can and does watch its actions carefully in this regard. If the Committee fails to adjust its chosen level of accommodation appropriately in response to changes in economic conditions, the public may well begin to doubt the Committee’s claims about its goals.

What economic conditions are relevant? Again, I think that it’s useful to think of a car driver who is trying to maintain his speed. To know how much (or how little) acceleration to provide, the driver would certainly like to know his current speed. As well, he would like to know how future road conditions—like hills—are likely to affect his future speed. The FOMC’s problem is quite similar. Just like the driver needs to know his current speed, the FOMC needs an accurate measure of current inflation and unemployment. Just as the driver needs an estimate of his future speed, based on anticipated road conditions, the FOMC should have an assessment of the future levels of inflation and unemployment.

I find it helpful to summarize the relevant information in what I term a mandate dashboard. The dashboard provides real-time readings on current and expected inflation and unemployment. Here’s what the dashboard looked like in the FOMC meeting earlier this month.

Large Image

I’ll explain the dashboard starting with the inflation side. The first cell from the left is current inflation. The second cell is what inflation is projected to be in one year’s time. Finally, the third cell contains a forecast for inflation in two years’ time. The unemployment side is similar. The first cell from the left represents current unemployment. The second cell represents a forecast for unemployment in one year’s time, and the third cell is a forecast for unemployment in two years’ time.

Of course, I have to be a little more precise in what I mean by inflation and unemployment. By “inflation,” I mean the change in the Personal Consumption Expenditure Price Index over the preceding four quarters, excluding changes in the prices of food and energy.² Hence, my measure of inflation in the dashboard is what is commonly called “core inflation.” I’m using core inflation because I view it as a good measure of overall inflationary pressures over the next two to three years.

By “unemployment,” I mean the unemployment rate averaged over the three months in the current quarter.³ The forecasts for future inflation and unemployment are the midpoints of the central tendencies of the projections of FOMC participants that they released in November.

It is important to note that the dashboard includes information from other current variables besides inflation and unemployment. The forecasts for inflation and unemployment could potentially be based on a wide range of information—anticipated changes in fiscal policy, changes in European financial markets and so on. So, basing policy on the mandate dashboard does allow policy to react to changes in these other economic variables. However, using this kind of dashboard does require monetary policy to respond to any economic variable only insofar as that variable affects current and future inflation or unemployment. This restriction seems appropriate given the limited nature of the FOMC’s statutory assignment from Congress.

Given this mandate dashboard, how should the level of accommodation evolve over time in response to changes in dashboard readings? There are many subtleties associated with providing a general answer to this question, including the key trade-off that I mentioned earlier between the two mandates. But there are two relatively common and important instances in which the mandate dashboard becomes straightforward to use in a qualitative way. Suppose inflation and expected inflation rise and unemployment and expected unemployment fall, as is often true in a recovery. Then, regardless of how it weights the two mandates, the FOMC should reduce the level of accommodation. In contrast, suppose inflation and expected inflation go down and unemployment and expected unemployment go up, as is often true when the economy slows. Then, regardless of how it weights the two mandates, the FOMC should increase the level of accommodation.

A public contingency plan for 2012 would specify the FOMC’s actions under a number of scenarios for the mandate dashboard in a year’s time. It is natural to start with the scenario that the current FOMC’s projections for 2012 turn out to be correct.

Large Image

Notice that the second cell of the November 2012 row is the forecast for inflation over the course of 2013, and the second cell of the November 2011 row is the forecast for inflation over the course of 2012. We generally think that monetary policy operates with a one- or two-year lag. Accordingly, the dashboard keeps track of what we expect the economy to be like in a year or two.

By comparing the second row of the table with the first row, we can see that in this scenario, core inflation, and its outlook, will be about the same in a year’s time. Unemployment will be lower. These changes in the dashboard readings suggest that, in the scenario that the economy evolves in 2012 as the Committee expects, the Committee should reduce the level of monetary accommodation over the course of 2012.

How would the Committee accomplish this reduction? Right now, the Committee is projecting that it will keep its target short-term interest rate extraordinarily low for at least six to seven quarters. In my view, it would be simplest to reduce the level of accommodation by changing that estimate to a shorter period of time.⁴

But, like those of many private sector forecasters, the FOMC’s projections have proven imperfect over the past few years. With that in mind, the Committee should provide public guidance on how it will respond to other scenarios in 2012. Suppose, for example, that the following scenario occurs in 2012, in which economic conditions are worse than expected.

Large Image

In this alternative scenario, inflation has fallen since November 2011 and unemployment has risen since November 2011. These changes imply that the Committee should increase the level of accommodation over the course of the year. Recall that the Committee is currently projecting that it will keep interest rates extraordinarily low for at least six to seven quarters. The Committee could increase the level of accommodation in 2012 by changing the estimate of at least six to seven quarters to some longer period of time. Alternatively, it could increase accommodation by purchasing additional long-term securities issued by the federal government or by government-sponsored enterprises.

An Inconsistency in the Making of Recent Monetary Policy

I’ve been talking about how a mandate dashboard can be helpful in formulating a public contingency plan for monetary policy in 2012. However, the mandate dashboard also clarifies an important inconsistency in the making of recent monetary policy.

I became president of the Federal Reserve Bank of Minneapolis in October 2009. I attended my first FOMC meeting in November 2009, as a nonvoter. So, when I think about current monetary policy, I find it natural to look back at the position of the mandate dashboard at my first meeting:

Large Image

The dashboard points out that economic conditions were quite grim at that meeting. The Committee expected low inflation, and ongoing disinflation, over 2010 and 2011. Unemployment was expected to average well above 9 percent over 2010 and 2011.

The situation two years later, while hardly ideal, has improved markedly. Hence, I would say that the evolution of the dashboard readings suggests that monetary policy should be less accommodative now than it was in November 2009. But in fact, through choices dating back to last November, the Committee has made monetary policy considerably more accommodative.

I should underscore one point. Like many private sector forecasters, the FOMC has overestimated the strength of the recovery over the past two years. Thus, in November 2009, the Committee expected the unemployment rate in the fourth quarter of 2011 to be 8.4 percent instead of around 9 percent. This observation does imply that the Committee’s current level of accommodation should be larger than what the Committee expected it to be two years ago. It does not imply that the Committee’s current level of accommodation should be higher than what the Committee had in place two years ago.

How should an outside observer interpret this inconsistency between the evolution of the mandate dashboard’s readings and the Committee’s actions? Earlier in my speech, I set forth what I see as a key trade-off involved in the making of monetary policy. There is a benefit to adding monetary accommodation: It reduces unemployment. There is a cost to adding monetary accommodation: It increases the risk of inflation running above the Committee’s objective of 2 percent for multiple years. The FOMC’s actions in 2011 suggest that the Committee is now more concerned about high unemployment, and correspondingly less concerned about the possibility of higher-than-target inflation.

Just to be clear: I view the Committee’s current resolution of the trade-off between inflation and unemployment as being justifiable. I also viewed the Committee’s resolution of this trade-off in 2009 as being justifiable. However, what I see as problematic is that the Committee’s resolution of this trade-off seems to be changing over time. In particular, the Committee’s actions in 2011 suggest that it is now more willing to tolerate higher-than-target inflation than it was in 2009. If this possible drift in inflation tolerance were to persist, or were expected to persist, it could give rise to a damaging increase in inflationary expectations. Undoing such an increase in inflationary expectations, as Americans discovered in the early 1980s, requires drastic policy steps that have extremely painful consequences for employment. It is exactly in this sense that I have said in earlier speeches that the Committee’s actions in 2011 served to weaken the Committee’s credibility.

I believe that it is critical for the Committee to avoid further drift in its resolution of the key trade-off between inflation and unemployment. It can accomplish this goal by formulating and following a public contingency plan that is explicitly grounded in metrics like the mandate dashboard. Of course, no contingency plan can ever be definitive. Inevitably, the FOMC will learn things that it did not expect to learn. And so there may be conditions that force the FOMC to deviate from a chosen plan. However, having a public plan, and couching its decisions against the backdrop of that plan, will enhance Federal Reserve transparency, credibility, accountability and consistency.

In May 2010, Chairman Bernanke stated, “Transparency regarding monetary policy … not only helps make central banks more accountable, it also increases the effectiveness of policy.”⁵ I agree completely with this sentiment. And I see a public contingency plan, based on the explicit use of metrics like the mandate dashboard, as promoting exactly the kind of transparency that Chairman Bernanke then described.

Thanks for listening. I’m happy to take your questions.

Endnotes

Some FOMC Basics

Let me begin with some basics about the Federal Reserve System. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and by area, we’re the second largest. Our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the FOMC meets to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Currently, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually. Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas and Chicago Federal Reserve Banks.

I’ve said that the FOMC meets (at least) eight times per year. But how do these meetings work? At a typical meeting, there are two so-called go-rounds, in which every president and every governor has the opportunity to speak without interruption. The first of these is referred to as the economics go-round. It is kicked off by a presentation on current economic conditions by Federal Reserve staff economists. Then, the presidents and governors describe their individual views on current economic conditions and their respective outlooks for future economic conditions. The presidents typically start by providing information about their district’s local economic performance. We get that information from our research staffs, but also from our interactions with business and community leaders in industries and towns from across our districts.

The Committee next turns to the second go-round, which focuses on policy. Again, the staff begins, with a presentation of policy options. After that, each of the 17 meeting participants has a chance to speak on what each views as the appropriate policy choice. This set of remarks is followed with a summary by the chairman, in which he lays out what he sees as the Committee’s consensus view for future policy. The voting members of the FOMC then cast their votes on this policy statement and thereby set monetary policy for the next six to seven weeks.

This description of an FOMC meeting highlights how the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. And, as I’ve described, their input relies critically on information received from district residents. In this way, the Federal Reserve System is deliberately designed to give the residents of Main Street a voice in national monetary policy.

FOMC Objectives

I’ve said that FOMC participants seek to adopt what they view as the appropriate policy choice. That provides a natural segue into my next topic: the policy objectives of the FOMC. The FOMC has a dual mandate, established by Congress: to set monetary policy so as to promote price stability and maximum employment. The heart of the price stability mandate is the Federal Reserve’s inflation objective. The FOMC communicates its inflation objective to the public in a number of ways. Most prominently, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation in the longer run (maybe five or six years), assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.”

Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. An important and ongoing communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. Changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

Looking Back over the Past Four Years: Actions

The National Bureau of Economic Research’s Business Cycle Dating Committee serves as the official arbiter of precisely when recessions begin and end in the United States.¹The committee has determined that what is commonly referred to as the Great Recession began in December 2007 and ended in June 2009. During that time period, real gross domestic product (that is, GDP adjusted for inflation) fell by 5 percent and unemployment nearly doubled.

The Federal Reserve responded to the Great Recession and the associated financial crisis in a number of ways that fall roughly into two classes. First, the Fed engaged in a vast amount of lending to firms believed to be in sound condition. It lent through conventional vehicles like the discount window and currency swaps with foreign central banks. But it also lent through relatively unconventional vehicles like the Term Asset-Backed Securities Loan Facility.² Second, the Fed lowered the real interest rate facing borrowers and lenders.

Here, I should clarify some terminology. By the term “real interest rate,” I’m referring to the interest rate received by lenders net of inflation. Thus, if the interest rate on the loan is 5 percent per year and lenders expect inflation to be around 2 percent, the real interest rate is roughly 3 percent. Economists generally think that it’s the real interest rate that matters for economic decision-making.

I’ll first discuss the Fed’s lending responses and then talk about the interest rate cuts.

Lending

To understand the Fed’s lending response to the events of 2007-09, we need to step back to the second half of 2006. At that time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. They viewed those assets as being largely risk-free. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip, as they had over the preceding 10 years.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were learning the hard way that U.S. land was a risky investment. Now the only question was how risky. That uncertainty planted the seeds for global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present-value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a financial market that is functioning well, solvent firms are typically liquid because they can borrow against their future profits. During a financial panic, however, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, credit markets cease to function as well, and even highly solvent firms may become illiquid.

As I’ve said, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land in the mid-2000s. But by mid-2007, as those land prices fell, financial markets became increasingly uncertain about how to evaluate mortgage-backed securities and other assets backed by U.S. land. That translated into uncertainty about the ultimate solvency of institutions holding those assets—and then about the ultimate solvency of any of their creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly as the panic conditions took firmer hold.

Most economists agree that central banks should respond to financial panics by communicating that they are willing to lend freely to solvent firms, against a wide range of good collateral, at some kind of penalty rate. This policy is useful for two reasons. First, it provides a source of funds to potential borrowers who are illiquid but nonetheless solvent. Second, it provides a floor to collateral valuation. Private lenders know that they can always use collateral seized from a defaulting borrower as a vehicle to borrow money from the central bank. That baseline use serves to spur private lending.

Beginning in mid-2007, the Fed took a number of actions consistent with this operating principle. It lent money to financial institutions through the discount window and its close cousin, the Term Auction Facility. It injected liquidity into a broad range of essential credit markets through a veritable alphabet soup of special lending vehicles. In some sense, these interventions were typical for a central bank operating in the context of a financial panic. But the size of the problem meant that the operations were unprecedented in their scale. The interventions ultimately made up more than $1 trillion of Federal Reserve assets.

There is no doubt that these interventions saved many solvent firms from collapse during the financial crisis. Over time, panic eased and spreads in financial markets normalized. Once that happened, the private sector stopped borrowing from the Fed because it found the Fed’s penalty rates too onerous. As a result, the Fed shut down its special lending facilities in 2010.

It is plausible that the Fed’s loans through the various special facilities exposed it—and by extension, the American public—to some risk of loss. However, it is difficult to know how much risk was involved. We generally try to measure a financial asset’s risk by the spread between its yield and that of a safe benchmark like U.S. Treasuries. But as I’ve mentioned, in a financial panic a relatively large fraction of such a spread is attributable to illiquidity as opposed to intrinsic risk. The goal of the central bank’s intervention is exactly to eliminate this panic-driven illiquidity. Accordingly, we cannot gauge the Fed’s risk exposures without somehow correcting spreads for this illiquidity factor. Calculating this, however, is extremely difficult. What we can say with certainty is that the Fed has not lost a penny on any of these transactions: All such loans have been repaid in full.

I should be careful to distinguish the lending that I’ve described from the institution-specific assistance the Federal Reserve provided to firms like AIG. These institution-specific interventions were deemed necessary by the Fed and the Bush administration because they believed that there were no adequate procedures in place for liquidating the assets of systemically important financial institutions in an orderly fashion. In 2010, the U.S. Congress passed an act that provides these procedures. Simultaneously—and correctly—the Congress removes the Fed’s ability to engage in institution-specific assistance. The act does leave in place the Fed’s ability to engage in broad-based market interventions of the kind that I’ve described, albeit with more congressional and White House oversight. This ability of the Fed could be useful in the event that financial market turmoil in other parts of the world ever threatens to spread to U.S. credit and capital markets.

Cutting Interest Rates

I’ve talked about how the fall in land prices generated a sharp increase in risk perceptions in financial markets and how that in turn led to a financial crisis. I now want to turn to what I see as the second key effect of the fall in land prices. This fall reduced the net worth of many households and firms. According to Fed calculations, household net worth fell by over 25 percent from the second quarter of 2007 to the first quarter of 2009. Households responded to this change in their balance sheets by forgoing consumption, which led in turn to a fall in output and employment,³ and put downward pressure on the price level.

The FOMC reacted by lowering its target interest rate from 5.25 percent in August 2007 to a range of 0 to 0.25 percent in December 2008; it now remains at this lower bound. Since inflation expectations remained stable, the FOMC’s action has had the effect of lowering the real interest rate facing households. Households, of course, typically respond to lower rates by saving less and demanding more consumption. Similarly, firms undertake more investment projects. In this way, the FOMC can and has partially offset the impact on the economy of the loss of net worth.

Indeed, the FOMC would probably have liked to respond by cutting its target interest rate still further. The problem is that this target interest rate cannot go below zero. Instead, the FOMC has engaged in large-scale purchases of long-term assets issued or backed by the government. The goal of these transactions is to lower long-term real interest rates and again offset the impact on the economy of the net worth shock.

So, to sum up, the fall in land prices triggered an increase in risk perceptions and a decrease in household net worth. The increase in risk led to a major financial crisis, which the Federal Reserve addressed through a large amount of broad-based lending. The decrease in net worth led to a major recession and ongoing slow recovery. The Federal Reserve’s reduction in interest rates has lessened the impact of this change in net worth.

Looking Back over the Past Four Years: Outcomes

How has the Federal Reserve performed relative to its dual mandate over the past four years, since the onset of the Great Recession at the end of 2007? In terms of price stability, the answer is remarkably well. The personal consumption expenditure (PCE) inflation rate has averaged 1.8 percent per year from the fourth quarter of 2007 through the third quarter of 2011. In my view, this outcome is essentially consistent with price stability.

Now, I want to be clear here about what I mean when I say “inflation.” That number I just gave you, 1.8 percent per year for nearly four years, refers to what’s termed headline inflation. It includes all goods and services, including food and energy. When the Fed says that it is committed to keeping inflation at 2 percent or a little less, it means prices for all goods and services, including the gas we put in our cars and the food we put on our tables. When we make reference to year-over-year core inflation—that is, inflation without food and energy—it’s only because we believe that core inflation is a helpful predictor of headline inflation over the next three or four years.

It is important, I think, to understand why there is no longer an intrinsic connection between the size of the Fed’s balance sheet and inflation. In the past three years, the Fed has bought over $2 trillion of securities issued or backed by the government. The Fed has funded that purchase by tripling the amount of deposits held by banks with the Fed—what are called bank reserves.

The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are essentially licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. And if you took any economics in school you learned: More money chasing the same number of goods—voilà, inflation.

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

I’m confident, though, that at some point in the future, the economy will improve and banks will once again have good lending opportunities. Some observers are concerned that once this happens, the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation. The Fed’s ability to pay interest on reserves means that the old and familiar link between increased bank reserves and higher inflation has been broken.

Of course, this requires the Fed to raise the interest rate on reserves in response to changes in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently timely and effective manner to keep inflation at 2 percent or a little less? But that’s always been the key question to ask about Fed policy, even when the Fed had a much smaller balance sheet. And that’s my point: Because the Fed can pay interest on reserves, the size of its balance sheet does not, in and of itself, undercut the credibility of its commitment to keep inflation at 2 percent or a bit under. I believe that’s why both survey and market-based measures of expected inflation over the next five to 10 years have remained remarkably stable as the Fed has expanded its liabilities.

In terms of the Fed’s employment mandate: Unemployment remains disturbingly high at 9 percent. But—and this is important to keep in mind—it would likely be much higher without Federal Reserve interventions. Suppose the Fed had not followed its aggressive lending policies or its imaginative forms of monetary accommodation. What would have happened to the economy? While a definitive answer is impossible, the evidence from the Great Depression is suggestive. In the early years of the Great Depression, the United States was on the gold standard and the Fed could not easily adjust the quantity of bank reserves. As a result, the Fed did not engage in broad-based lending during the 1929-33 period. Nor did it cut interest rates aggressively. By 1933, hosts of financial institutions had failed, real GDP had fallen by over 25 percent, unemployment was 25 percent and the nation had experienced annual double-digit rates of deflation. The Fed’s passiveness in 1929-33 was associated with an economic catastrophe.

Let me summarize my review of Federal Reserve performance since the beginning of the Great Recession in December 2007. My assessment is that, despite profound economic shocks, the Federal Reserve—led by Chairman Bernanke—has successfully met its price stability mandate through its lending programs and through innovative forms of monetary accommodation. These actions also helped keep the unemployment rate from rising even higher. As part of its accommodative policy, the FOMC has greatly expanded its balance sheet. But it is important to understand that this expansion need not trigger inflation now or in the future, because the Federal Reserve can now pay interest on bank reserves.

Going Forward

I’ve spent most of this speech looking back. Let me close by offering some thoughts about future policy.

I’ve underscored the Federal Reserve’s success in meeting its price stability mandate over the past four years. And the Fed’s actions have helped keep unemployment from rising higher. But the unemployment rate, currently 9 percent, remains disturbingly high—and FOMC meeting participants are projecting that it will fall to only about 8 percent over the next two years.

The FOMC does have tools remaining. It could put downward pressure on long-term market interest rates in at least two ways. First, it could buy more long-term Treasury securities or securities issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. Second, the Committee could extend its prediction for how long it will keep its target short-term interest rate exceptionally low. So, tools—and choices—remain.

However, the FOMC should do more than simply decide at each meeting whether or not to buy more assets or to keep interest rates low for longer. Any current decision is based on the FOMC’s forecast of the future, and no forecast can be perfect. The Committee should provide a public contingency plan—that is, provide clear guidance on how it will respond to a variety of relevant scenarios. For example, the Committee recently projected that in 2011, core inflation will be 1.9 percent and that it will fall back in 2012 and 2013 to around 1.7 percent. Suppose hypothetically that core inflation, and the outlook for core inflation, has risen to 3 percent by the end of 2013, while unemployment has fallen to between 8 percent and 8.5 percent. A public contingency plan would allow the public to know what the Committee intends to do in that eventuality.

I believe that public contingency planning will have many benefits. Let me mention two. First, in recent statements and speeches, I have described why the FOMC actions in August and September seemed inconsistent with the evolution of the macroeconomic data in 2011. This kind of inconsistency is much less likely to occur once the FOMC has formulated an explicit public contingency plan. Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. A public FOMC contingency plan can help reduce the level of policy uncertainty being created by the Fed.

No contingency plan can ever be definitive. Inevitably, the FOMC will learn things that it did not expect to learn. And so there may be conditions that force the FOMC to deviate from a chosen plan. However, having a public plan, and couching its decisions against the backdrop of that plan, will enhance Federal Reserve transparency, credibility, accountability and consistency.

Thank you for listening. I’d be happy to take your questions.

Endnotes

References

Some FOMC Basics

Let me begin, though, with some basics about the Federal Reserve System. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and by area, we’re the second largest. Our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the FOMC meets to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Currently, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually. Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas and Chicago Federal Reserve Banks.

I’ve said that the FOMC meets (at least) eight times per year. But how do these meetings work? At a typical meeting, there are two so-called go-rounds, in which every president and every governor has the opportunity to speak without interruption. The first of these is referred to as the economics go-round. It is kicked off by a presentation on current economic conditions by Federal Reserve staff economists. Then, the presidents and governors describe their individual views on current economic conditions and their respective outlooks for future economic conditions. The presidents typically start by providing information about their district’s local economic performance. We get that information from our research staffs, but also from our interactions with business and community leaders in industries and towns from across our districts.

The chairman speaks at the end of the first go-round. He briefly but thoroughly summarizes the preceding 16 perspectives. I can assure you that this is no easy task—and the chairman’s balanced and thoughtful treatment of our remarks is one of the many reasons that he commands such respect among his colleagues. He then provides his own views on the economy.

The Committee next turns to the second go-round, which focuses on policy. Again, the staff begins, with a presentation of policy options. After that, each of the 17 meeting participants has a chance to speak on what each views as the appropriate policy choice. This set of remarks is followed with a summary by the chairman, in which he lays out what he sees as the Committee’s consensus view for future policy. The voting members of the FOMC then cast their votes on this policy statement and thereby set monetary policy for the next six to seven weeks.

I hope that this description of an FOMC meeting conveys two things. First, the meeting participants view monetary policy as a largely technocratic exercise that is fundamentally apolitical. As I mentioned earlier, our policy discussions are largely based on information-gathering and model analyses by meeting participants and their staffs. I would say that the tone of the discussion is pretty much in accord with its rather technical substance. There is disagreement, of course. How could there not be in such challenging and unusual economic times? But, as a relative newcomer, I’ve been impressed with how the dialogue within the meeting room is always fundamentally grounded in a deep respect for the job at hand and for each other.

Second, my description of an FOMC meeting highlights how the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. And, as I’ve described, their input relies critically on information received from district residents. In this way, the Federal Reserve System is deliberately designed to give the residents of Main Street a voice in national monetary policy.

FOMC Objectives

I’ve said that FOMC participants seek to adopt what they view as the appropriate policy choice. That provides a natural segue into my next topic: the policy objectives of the FOMC. The FOMC has a dual mandate, established by Congress: to set monetary policy so as to promote price stability and maximum employment. The heart of the price stability mandate is the Federal Reserve’s inflation objective. The FOMC communicates its inflation objective to the public in a number of ways. Most prominently, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation in the longer run (maybe five or six years), assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.”

Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. An important and ongoing communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. Changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

Looking Back over the Past Four Years: Actions

The National Bureau of Economic Research’s Business Cycle Dating Committee serves as the official arbiter of precisely when recessions begin and end.¹ The committee has determined that what is commonly referred to as the Great Recession began in December 2007 and ended in June 2009. During that time period, real gross domestic product (that is, GDP adjusted for inflation) fell by 5 percent and unemployment nearly doubled.

The Federal Reserve responded to the Great Recession and the associated financial crisis in a number of ways that fall roughly into two classes. First, the Fed engaged in a vast amount of lending to firms believed to be in sound condition. It lent through conventional vehicles like the discount window and currency swaps with foreign central banks. But it also lent through relatively unconventional vehicles like the Term Asset-Backed Securities Loan Facility.² Second, the Fed lowered the real interest rate facing borrowers and lenders.

Here, I should clarify some terminology. By the term “real interest rate,” I’m referring to the interest rate received by lenders net of inflation. Thus, if the interest rate on the loan is 5 percent per year and lenders expect inflation to be around 2 percent, the real interest rate is roughly 3 percent. Economists generally think that it’s the real interest rate that matters for economic decision-making.

Early in the recession, the Fed lowered its target for the fed funds rate. Given that inflation expectations remained stable, this action served to lower the real interest rate. By early 2009, when the fed funds rate target could really go no lower, the Fed used large-scale asset purchases to achieve further reductions in the real interest rate.

I’ll first discuss the Fed’s lending responses and then talk about the interest rate cuts.

Lending

To understand the Fed’s responses to the events of 2007-09, we need to step back to the second half of 2006. At that time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. They viewed those assets as being largely risk-free. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip, as they had over the preceding 10 years.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were learning the hard way that U.S. land was a risky investment. Now the only question was how risky. That uncertainty planted the seeds for global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present-value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a financial market that is functioning well, solvent firms are typically liquid because they can borrow against their future profits. During a financial panic, however, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, credit markets cease to function as well, and even highly solvent firms may become illiquid.

As I’ve said, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land in the mid-2000s. But by mid-2007, as those land prices fell, financial markets became increasingly uncertain about how to evaluate mortgage-backed securities and other assets backed by U.S. land. That translated into uncertainty about the ultimate solvency of institutions holding those assets—and then about the ultimate solvency of any of their creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly as the panic conditions took firmer hold.

Most economists agree that central banks should respond to financial panics by communicating that they are willing to lend freely to solvent firms, against a wide range of good collateral, at some kind of penalty rate. This policy is useful for two reasons. First, it provides a source of funds to potential borrowers who are illiquid but nonetheless solvent. Second, it provides a floor to collateral valuation. Private lenders know that they can always use collateral seized from a defaulting borrower as a vehicle to borrow money from the central bank. That baseline use serves to spur private lending.

Beginning in mid-2007, the Fed took a number of actions consistent with this operating principle. It lent money to financial institutions through the discount window and its close cousin, the Term Auction Facility. It injected liquidity into a broad range of essential credit markets through a veritable alphabet soup of special lending vehicles. In some sense, these interventions were typical for a central bank operating in the context of a financial panic. But the size of the problem meant that the operations were unprecedented in their scale. The interventions made up more than $1 trillion of Federal Reserve assets.

There is no doubt that these interventions saved many solvent firms from collapse during the financial crisis. Over time, panic eased and spreads in financial markets normalized. Once that happened, the private sector stopped borrowing from the Fed because it found the Fed’s penalty rates too onerous. As a result, the Fed shut down its special lending facilities in 2010.

It is plausible that the Fed’s loans through the various special facilities exposed it—and by extension, the American public—to some risk of loss. However, it is difficult to know how much risk was involved. We generally try to measure a financial asset’s risk by the spread between its yield and that of a safe benchmark like U.S. Treasuries. But as I’ve mentioned, in a financial panic a relatively large fraction of such a spread is attributable to illiquidity as opposed to intrinsic risk. The goal of the central bank’s intervention is exactly to eliminate this panic-driven illiquidity. Accordingly, we cannot gauge the Fed’s risk exposures without somehow correcting spreads for this illiquidity factor. Calculating this, however, is extremely difficult. What we can say with certainty is that the Fed has not lost a penny on any of these transactions: All such loans have been repaid in full.

I should be careful to distinguish the lending that I’ve described from the institution-specific assistance the Federal Reserve provided to firms like AIG. These institution-specific interventions were deemed necessary by the Fed and the Bush administration because they believed that there were no adequate procedures in place for liquidating the assets of systemically important financial institutions in an orderly fashion. The Dodd-Frank Act passed in 2010 provides these procedures. Simultaneously—and correctly—the Dodd-Frank Act removes the Fed’s ability to engage in institution-specific assistance. The act does leave in place the Fed’s ability to engage in broad-based market interventions of the kind that I’ve described, albeit with more congressional and White House oversight.

Cutting Interest Rates

I’ve talked about how the fall in land prices generated a sharp increase in risk perceptions in financial markets and how that in turn led to a financial crisis. I now want to turn to what I see as the second key effect of the fall in land prices. This fall reduced the net worth of many households and firms. According to Fed calculations, household net worth fell by over 25 percent from the second quarter of 2007 to the first quarter of 2009. Households responded to this change in their balance sheets by forgoing consumption, which led in turn to a fall in output and employment,³ and put downward pressure on the price level.

The FOMC reacted by lowering its target interest rate from 5.25 percent in August 2007 to a range of 0 to 0.25 percent in December 2008; it now remains at this lower bound. Since inflation expectations remained stable, the FOMC’s action has had the effect of lowering the real interest rate facing households. Households, of course, typically respond to lower rates by saving less and demanding more consumption. Similarly, firms undertake more investment projects. In this way, the FOMC can and has partially offset the impact on the economy of the loss of net worth.

Indeed, the FOMC would probably have liked to respond by cutting its target interest rate still further. The problem is that this target interest rate cannot go below zero. Instead, the FOMC has engaged in large-scale purchases of long-term assets issued or backed by the government. The goal of these transactions is to lower long-term real interest rates and again offset the impact on the economy of the net worth shock.

So, to sum up, the fall in land prices triggered an increase in risk perceptions and a decrease in household net worth. The increase in risk led to a major financial crisis that has been cured, thanks in part to the actions by the Federal Reserve that I’ve just described. The decrease in net worth led to a major recession and ongoing slow recovery. The Federal Reserve’s reduction in interest rates has lessened the impact of this change in net worth.

Looking Back over the Past Four Years: Outcomes

How has the FOMC performed relative to its dual mandate over the past four years, since the onset of the Great Recession at the end of 2007? In terms of price stability, the answer is remarkably well. The personal consumption expenditure (PCE) inflation rate has averaged 1.8 percent per year from the fourth quarter of 2007 through the third quarter of 2011. In my view, this outcome is essentially consistent with price stability.

Now, I want to be clear here about what I mean when I say “inflation.” That number I just gave you, 1.8 percent per year for nearly four years, refers to what’s termed headline inflation. It includes all goods and services, including food and energy. When the Fed says that it is committed to keeping inflation at 2 percent or a little less, it means prices for all goods and services, including the gas we put in our cars and the food we put on our tables. When we make reference to year-over-year core inflation—that is, inflation without food and energy—it’s only because we believe that core inflation is a helpful predictor of headline inflation over the next three or four years.

I want to spend some time explaining why there is no longer an intrinsic connection between the size of the Fed’s balance sheet and inflation. In the past three years, the Fed has bought over $2 trillion of securities issued or backed by the government. The Fed has funded that purchase by tripling the amount of deposits held by banks with the Fed—what are called bank reserves.

The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are essentially licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. And if you took any economics in school you learned: More money chasing the same number of goods—voilà, inflation. Indeed, I think I’m pretty safe in saying that after four years in economics grad school, I’ve uttered this phrase—more money chasing the same number of goods creates inflation—more often than anyone else in this room.

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

I’m confident, though, that at some point in the future, the economy will improve and banks will once again have good lending opportunities. Some observers are concerned that once this happens, the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation. The Fed’s ability to pay interest on reserves means that the old and familiar link between increased bank reserves and higher inflation has been broken.

Of course, this requires the Fed to raise the interest rate on reserves in response to changes in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently timely and effective manner to keep inflation at 2 percent or a little less? But that’s always been the key question to ask about Fed policy, even when the Fed had a much smaller balance sheet. And that’s my point: Because the Fed can pay interest on reserves, the size of its balance sheet does not, in and of itself, undercut the credibility of its commitment to keep inflation at 2 percent or a bit under. I believe that’s why both survey and market-based measures of expected inflation over the next five to 10 years have remained remarkably stable as the Fed has expanded its liabilities.

Unemployment remains disturbingly high at 9 percent. But—and this is important to keep in mind—it would likely be much higher without Federal Reserve interventions. Suppose the Fed had not followed its aggressive lending policies or its imaginative forms of monetary accommodation. What would have happened to the economy? While a definitive answer is impossible, the evidence from the Great Depression is suggestive. In the early years of the Great Depression, the United States was on the gold standard and the Fed could not easily adjust the quantity of bank reserves. As a result, the Fed did not engage in broad-based lending during the 1929-33 period. Nor did it cut interest rates aggressively. By 1933, hosts of financial institutions had failed, real GDP had fallen by over 25 percent, unemployment was 25 percent and the nation had experienced annual double-digit rates of deflation. The Fed’s passiveness in 1929-33 was associated with an economic catastrophe.

Let me summarize my review of Federal Reserve performance since the beginning of the Great Recession in December 2007. My assessment is that, despite profound economic shocks, the Federal Reserve—led by Chairman Bernanke—has successfully met its price stability mandate through its lending programs and through innovative forms of monetary accommodation. These actions also helped keep the unemployment rate from rising even higher. As part of its accommodative policy, the FOMC has greatly expanded its balance sheet. But it is important to understand that this expansion need not trigger inflation now or in the future, because the Federal Reserve can now pay interest on bank reserves.

Going Forward

I’ve spent most of this speech looking back. Let me close by offering some thoughts about future policy.

I’ve underscored the Federal Reserve’s success in meeting its price stability mandate over the past four years. And the Fed’s actions have helped keep unemployment from rising higher. But the unemployment rate, currently 9 percent, remains disturbingly high—and FOMC meeting participants are projecting that it will fall to only about 8 percent over the next two years.

The FOMC does have tools remaining. It could put downward pressure on long-term market interest rates in at least two ways. First, it could buy more long-term Treasury securities or securities issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. Second, the Committee could extend its prediction for how long it will keep its target short-term interest rate exceptionally low. So, tools—and choices—remain.

However, the FOMC should do more than simply decide at each meeting whether or not to buy more assets or to keep interest rates low for longer. Any current decision is based on the FOMC’s forecast of the future, and no forecast can be perfect. The Committee should provide a public contingency plan—that is, provide clear guidance on how it will respond to a variety of relevant scenarios. For example, the Committee recently projected that in 2011, core inflation will be 1.9 percent and that it will fall back in 2012 and 2013 to around 1.7 percent. Suppose hypothetically that core inflation, and the outlook for core inflation, has risen to 3 percent by the end of 2013, while unemployment has fallen to between 8 percent and 8.5 percent. A public contingency plan would allow the public to know what the Committee intends to do in that eventuality.

I believe that this kind of public contingency planning will have many benefits. Let me mention two. First, in recent statements and speeches, I have described why the FOMC actions in August and September seemed inconsistent with the evolution of the macroeconomic data in 2011. This kind of inconsistency is much less likely to occur once the FOMC has formulated an explicit public contingency plan. Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. A public FOMC contingency plan can help reduce the level of policy uncertainty being created by the Fed.

No contingency plan can ever be definitive. Inevitably, the FOMC will learn things that it did not expect to learn, and events will occur that it did not expect to occur. And so there may be conditions that force the FOMC to deviate from a chosen plan. However, having a public plan, and couching its decisions against the backdrop of that plan, will enhance Federal Reserve transparency, credibility, accountability and consistency.

Thank you for listening. I’d be happy to take your questions.

Endnotes

References

Thank you very much for that generous introduction. It is a special pleasure to meet with this group so soon after the announcement that two of your fellow alums have been awarded the 2011 Prize in Economic Sciences in Memory of Alfred Nobel. I am referring, of course, to Thomas Sargent and Christopher Sims, and I would like to begin my remarks by congratulating Tom and Chris on this well-deserved honor. In the 1970s, in independent research, they developed systematic approaches to distinguishing between cause and effect in macroeconomic data. Now, almost 40 years later, their thinking informs the making of macroeconomic policy around the world.

I am especially pleased to acknowledge Chris and Tom’s achievement because of their connection to the state of Minnesota. After earning their Ph.D.s in economics at Harvard, where Chris also received his undergrad degree in mathematics, Tom and Chris went on to do much of their Prize-winning work right here in Minneapolis, as professors at the University of Minnesota and consultants at the Federal Reserve Bank of Minneapolis. I’m sure that many of you in the room today followed that same career path, from an education at one of America’s oldest colleges to accomplishing great things here in the North Star State.

In my remarks today, I’d like to touch on several topics. I’ll begin with a quick description of the structure of the Federal Reserve System and the deliberative process of the Federal Open Market Committee—the Committee that makes monetary policy for the nation. Then I’ll describe the FOMC’s objectives and discuss how the FOMC makes decisions so as to achieve those objectives. I’ll close with a discussion of my dissents on recent FOMC decisions and some perspectives on monetary policy going forward. After that, I’ll be pleased to answer any questions you may have. And before I begin, I should remind you that my comments here today reflect my views alone, and not necessarily those of others in the Federal Reserve System, including my FOMC colleagues.

Some FOMC basics

The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and by area, we’re the second largest. Our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the FOMC meets to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Currently, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually. Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas and Chicago Federal Reserve Banks.

I’ve said that the FOMC meets (at least) eight times per year. But how do these meetings work? At a typical meeting, there are two so-called go-rounds, in which every president and every governor has the opportunity to speak without interruption. The first of these is referred to as the economics go-round. It is kicked off by a presentation on current economic conditions by Federal Reserve staff economists. Then, the presidents and governors describe their individual views on current economic conditions and their respective outlooks for future economic conditions. The presidents typically start by providing information about their district’s local economic performance. We get that information from our research staffs, but also from our interactions with business and community leaders in industries and towns from across our districts.

The chairman speaks at the end of the first go-round. He briefly but thoroughly summarizes the preceding 16 perspectives. I can assure you that this is no easy task—and the chairman’s balanced and thoughtful treatment of our remarks is one of the many reasons that he commands such respect among his colleagues. He then provides his own views on the economy.

The Committee next turns to the second go-round, which focuses on policy. Again, the staff begins, with a presentation of policy options. After that, each of the 17 meeting participants has a chance to speak on what each views as the appropriate policy choice. This set of remarks is followed by a summary by the chairman, in which he lays out what he sees as the Committee’s consensus view for future policy. The voting members of the FOMC then cast their votes on this policy statement and thereby set monetary policy for the next six to seven weeks.

I hope that this description of an FOMC meeting conveys two things. First, the meeting participants view monetary policy as a largely technocratic exercise that is fundamentally apolitical. As I mentioned earlier, our policy discussions are largely based on information-gathering and model analyses by meeting participants and their staffs. I would say that the tone of the discussion is pretty much in accord with its rather technical substance. There is disagreement, of course. How could there not be in such challenging and unusual economic times? But, as a relative newcomer, I’ve been impressed with how the dialogue within the meeting room is always fundamentally grounded in a deep respect for the job at hand and for each other.

Second, my description of an FOMC meeting highlights how the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. And, as I’ve described, their input relies critically on information received from district residents. In this way, the Federal Reserve System is deliberately designed to give the residents of Main Street a voice in national monetary policy.

FOMC objectives

I’ve said that FOMC participants seek to adopt what they view as the appropriate policy choice. That provides a natural segue into my next topic: the policy objectives of the FOMC. The FOMC has a dual mandate, established by Congress: to set monetary policy so as to promote price stability and maximum employment. In my view, the heart of implementing the price stability mandate is to formulate and communicate an objective for inflation. The central bank then fulfills its price stability mandate by making choices over time so as to keep inflation close to that objective.

Of course, the central bank’s job is complicated by economic shocks that may lower or raise inflationary pressures. The central bank provides additional monetary accommodation—like lower interest rates—in response to the shocks that push down on medium-term inflation. It reduces accommodation in response to the shocks that push up on inflation. By doing so, it works to ensure that inflation stays close to its objective.

It is not enough to have an objective—the Federal Reserve must also communicate that objective clearly and credibly. That communication serves to anchor the public’s medium- and long-term inflationary expectations. Put another way, without clear communication of objectives, the public can only guess at the intentions of the FOMC, and inflationary expectations and inflation itself will inevitably end up fluctuating—and perhaps by a lot. It is possible to undo these shifts in expectations, but doing so entails significant economic cost. The nation saw this all too clearly in the early 1980s, when tighter monetary policy necessary to rein in high inflation resulted in painful employment losses.

The Federal Reserve communicates its objective for inflation in a number of ways. For example, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation in the longer run (maybe five or six years), assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.”

Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. Some see an intrinsic conflict between the FOMC’s price stability mandate and maximum employment mandate. But there is actually a deep sense in which the price stability and maximum employment mandates are intertwined. Imagine that inflation runs at 3 or 4 percent per year for three or four years. The public will then start to doubt the credibility of the Fed’s stated commitment to a 2-percent-or-a-bit-under objective. The public’s medium-term inflationary expectations will consequently begin to rise. As we saw in the latter part of the 1970s, these changes in expectations can serve to reinforce and augment the upward drift in inflation. At that point, the Federal Reserve will have to tighten policy considerably if it wishes to regain control of inflation. But we learned in the early 1980s that the resultant tightening—while necessary—generates large losses in employment. In other words, failing to meet its price stability mandate can also lead the FOMC, over the medium and long term, to substantial failure on its employment mandate.²

An important and ongoing communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. Changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

Over the past year, the FOMC has communicated through its statements that it perceives the current unemployment rate to be elevated relative to levels that it views as consistent with its dual mandate. In this situation, there is a trade-off involved in the making of monetary policy. On the one hand, adding monetary accommodation reduces unemployment. On the other hand, adding accommodation increases the risk of generating inflation markedly higher than the Committee’s objective of 2 percent for a significant period of time. In choosing whether to add monetary stimulus or not, the Committee must resolve this trade-off between the fall in unemployment and the increase in the risk of inflation.

I’ve described the relevant trade-off in the traditional way as being one between employment gains and inflation risks. This description emphasizes a tension between the two mandates of the Federal Reserve. But, as I explained earlier, if the public observes inflation running at more than 2 percent for multiple years, their inflation expectations may drift upward. This increase in expectations can give rise to a need for monetary tightening that may generate large employment losses. In other words, when thinking about adding monetary accommodation, the Federal Reserve confronts a basic trade-off that can be framed without reference to its price stability mandate: a trade-off between short-term employment gains and the risk of larger longer-term employment losses.

Making monetary policy: Responding to a mandate dashboard

The FOMC’s dual mandate, as I’ve said, is to keep inflation at 2 percent or a bit under and to promote maximum employment—that is, to keep unemployment low. But how does the FOMC make its choices at each meeting so as to achieve these goals? I believe that it is useful to think of a driver who is trying to maintain a car speed. To do so, he’ll vary pressure on the accelerator in response to changes in road conditions, current and expected: hills, valleys, rough pavement, headwinds. In the same way, the FOMC varies its chosen level of monetary accommodation in response to changes in current and expected economic conditions.

This kind of systematic response to changing economic conditions is an essential part of good monetary policy for at least two reasons. First, there is a great deal of empirical evidence and theoretical support for the idea that following a policy rule, as economists call it, is what enables the Committee to achieve its dual mandate goals. Second, and perhaps more importantly, actions speak louder than words. The Committee can claim that it intends to make monetary policy so as to fulfill its dual mandate. But the public can and does watch its actions carefully in this regard. If the Committee fails to reduce its immense amount of accommodation in a timely fashion, the public may well begin to doubt the Committee’s claims about its goals.

Right now, the Federal Reserve has multiple forms of accommodative monetary policy in place. For example, the FOMC is targeting a fed funds rate of between 0 and 25 basis points—that is, between 0 percent and 0.25 percent. This kind of accommodation—keeping short-term interest rates extremely low—is an entirely conventional response to unduly low levels of inflation and unduly high levels of unemployment. By keeping market interest rates low, the policy encourages companies to invest in hiring and business expansion, and it encourages households to spend more. The Committee has announced that it anticipates that conditions will be such that the fed funds rate will stay between 0 and 25 basis points for at least 20 more months.

The second kind of accommodation is less conventional. The Fed has bought over $2 trillion of longer-term government securities and has announced its intention to buy still more. The goal of this form of accommodation is to raise the prices of longer-term securities and lower longer-term yields. In so doing, more long-term investments—like building factories or hiring workers—become more attractive to businesses.

This combined package of accommodation is really unprecedented. As I’ve described at some length in earlier speeches, I believe that it has been critical in keeping inflation from falling lower and unemployment from rising higher.³ But, as economic conditions improve, the FOMC will need to reduce the amount of accommodation that it is providing. What conditions are relevant? Again, I think that it’s useful to think of a car driver who is trying to maintain his speed. To know how much (or how little) acceleration to provide, the driver would certainly like to know his current speed. As well, he would like to know how future road conditions—like hills—are likely to affect his future speed.

The FOMC’s problem is quite similar. Just like the driver needs to know his current speed, the FOMC needs an accurate measure of current inflation and unemployment. Just as the driver needs an estimate of his future speed, based on anticipated road conditions, the FOMC should have an assessment of the future levels of inflation and unemployment.

I find it helpful to summarize the relevant information in what I term a mandate dashboard. For reasons that will become clear later in my remarks, I think that it’s useful to start by looking at the dashboard from early November 2010—that is, from about a year ago. I’ll explain the dashboard starting with the inflation side. The first cell from the left is current inflation. The second cell is what inflation is projected to be in one year’s time. Finally, the third cell contains a forecast for inflation in two years’ time. The unemployment side is similar. The first cell from the left represents current unemployment. The second cell represents a forecast for unemployment in one year’s time, and the third cell represents a forecast for unemployment in two years’ time.

Large Image

Of course, I have to be a little more precise in what I mean by inflation and unemployment. By “inflation,” I mean the change in the personal consumption expenditure (PCE) price index over the preceding four quarters, excluding changes in the prices of food and energy. Hence, my measure of inflation in the dashboard is what is commonly called “core inflation.” I’m using core inflation because I view it as a good measure of overall inflationary pressures over the next two to three years.

By “unemployment,” I mean the unemployment rate averaged over the three months in the current quarter. The forecasts for future inflation and unemployment are the midpoints of the central tendencies of the projections of FOMC participants that they released in November.

Just as a driver should adjust acceleration according to information provided by his dashboard, the FOMC should vary the level of monetary accommodation in response to changes in the mandate dashboard. The exact quantitative response will depend on the precise movements of the six variables and on how the FOMC is resolving the trade-off that I mentioned earlier between inflation risks and unemployment reductions. But the qualitative direction of the response is typically easier to determine. For example, the November 2010 dashboard shows that the FOMC expected the unemployment rate to fall over time—slowly—and the inflation rate to rise—slightly. As that happens, the FOMC should respond by slowly lowering its immense level of monetary accommodation.

Recent inconsistency in monetary policy actions

I picked November 2010 as a good base date because at that point in time, the FOMC added considerably to the level of monetary policy accommodation. The Committee undertook the purchase of $600 billion of long-term Treasuries over the following eight months, in what was called QE2. I supported this action within the meeting and then later publicly. The Committee took no further significant policy action until the last two meetings in August and September 2011, at which the FOMC added considerably more accommodation.

I dissented from the FOMC decisions at these last two meetings. My thinking behind those dissents is grounded in the evolution of the mandate dashboard over the past year. The entries for November 2010 are exactly what I’ve already shown you, and they’re based on the FOMC’s economic projections. The FOMC’s most recent 2011 projections date back to June, and so the entries for October 2011 are based on my own forecasts. The fourth quarter is not yet complete, but it looks like fourth-quarter-over-fourth-quarter PCE core inflation in 2011 will be around 1.9 percent. I expect it to rise over the next couple of years to slightly above 2 percent. At the same time, unemployment is 9.1 percent. I expect it to fall slowly to around 8 percent by the end of 2013. I should say that private sector forecasts for inflation over the next two years are probably closer to 1.6 percent rather than 2.1 percent. However, my forecasts for unemployment are roughly similar to those of private sector forecasters.

Large Image

Notice that the second cell for the November 2010 row is the forecast for inflation over the course of 2011, and the second cell for the October 2011 row is the forecast for inflation over the course of 2012. We generally think that monetary policy operates with a one- or two-year lag. Accordingly, the dashboard keeps track of what we expect the economy to be like in a year or two.

Regardless of whether my forecasts or the private sector forecasts are used, inflation—and the outlook for inflation—has risen markedly since last November. Unemployment—and the outlook for unemployment—has fallen. These changes in the mandate dashboard suggest that the Committee should have lowered the level of monetary accommodation over the course of the year. Instead, the Committee chose to raise the level of monetary accommodation. The Committee’s actions in the last two meetings are thus inconsistent with the evolution of the economy in 2011. Given this inconsistency between the Committee’s actions and the evolution of the economy, I decided to dissent in August and September.

I want to be clear about one important point. Like many private sector forecasters, the FOMC has overestimated the strength of the recovery over the past two years. Some have suggested that the unexpected slowness of the recovery is a justification for the FOMC’s increasing the level of monetary accommodation over the past couple of months. But I disagree with this argument. I’ve just described why the FOMC should respond to improvements in economic conditions and outlook with a reduction in the level of monetary accommodation. Logically, if the economy recovers much more slowly than expected, then the FOMC should respond by reducing the level of monetary accommodation much more slowly than expected. The FOMC should only increase accommodation if the economy’s performance and outlook, relative to the dual mandate, actually worsens over time.

Conclusions

Let me wrap up with some final thoughts about 2011 and a look ahead to 2012. Earlier in my speech, I set forth what I see as a key trade-off involved in the making of monetary policy. There is a benefit to adding monetary accommodation: It reduces unemployment. There is a cost to adding monetary accommodation: It increases the risk of inflation running above the Committee’s objective of 2 percent for multiple years. The FOMC’s actions in 2011 suggest that the Committee is resolving this key benefit-cost trade-off differently in 2011 from however it viewed the trade-off in 2010. In particular, it appears that the Committee is now more tolerant of the risk of higher-than-2-percent inflation than it was in 2010.

Moreover, as I explained earlier, one can reframe this trade-off in a way that is entirely separate from the price stability mandate. Higher-than-2-percent inflation over multiple years might lead to an upward drift in inflationary expectations. The Fed found in the 1970s that this upward drift could only be retarded by large medium- and long-term employment losses. Thus, I view the basic unemployment-inflation trade-off in the making of monetary policy as really being about short-term employment gains and the risk of larger longer-term employment losses. The FOMC’s actions in 2011 suggest that it is resolving this trade-off differently from however it viewed the trade-off in 2010. In particular, it appears that the Committee has reduced the weight that it is putting on the long term and increased the weight that it is putting on the short term.

Now, I should be clear: I don’t view the Committee’s current resolution of this trade-off as being intrinsically problematic. Nor did I view the Committee’s resolution of this trade-off in 2010 as being intrinsically problematic. What I do see as problematic is that the Committee’s resolution of this trade-off appears to be changing over time. In particular, the Committee’s actions in 2011 suggest that it is more willing to tolerate inflation risks—and the concomitant medium-term and long-term employment losses—than it was in 2010. If this drift in inflation risk tolerance were to persist, or were expected to persist, it could give rise to a damaging increase in inflationary expectations. It is exactly in this sense that I have said in earlier speeches that the Committee’s actions in 2011 served to weaken the Committee’s credibility.

But enough about the past—what about the future? I believe that the FOMC’s decision-making in 2011 has introduced a lack of clarity about its monetary policy mission. I believe that this lack of clarity can and should be addressed in two steps. First, the FOMC should explain how it plans to resolve the trade-off between inflation and unemployment in making its future decisions. Second, on an ongoing basis, the Committee should provide explicit communication about how its chosen actions are indeed consistent with its pre-announced resolution of the inflation-unemployment trade-off. Here, I believe that the use of metrics like the mandate dashboard provides a useful form of discipline—both on our own actions and on the public’s understanding of those actions.

In a speech he gave last May, Chairman Bernanke stated, “Transparency regarding monetary policy … not only helps make central banks more accountable, it also increases the effectiveness of policy.”⁴ I agree completely with this sentiment. And I see my two recommended future steps—clearer communication about trade-offs and the explicit use of metrics like the mandate dashboard—as promoting exactly the kind of transparency that Chairman Bernanke was describing.

Thank you for listening. I look forward to taking your questions.

Endnotes

Let me begin by welcoming all of you to the Federal Reserve Bank of Minneapolis to celebrate this auspicious event—the 50th anniversary celebration of the Minnesota Council on Economic Education (MCEE). Congratulations to all of you, including you teachers who have been a part of the Minnesota Council’s programs over the years, but especially to Claudia Parliament, who has served as director for nearly 20 of those 50 years, and who has done so with absolute commitment and professionalism. Indeed, it is hard to imagine the Minnesota Council without Claudia, but I understand that she will soon be leaving her post and handing her baton to her successor. Claudia, we thank you for your service and we wish you the best.

We are truly honored to host this event and are pleased that so many of you could make it here this evening. The Federal Reserve Bank of Minneapolis has long been a partner of the Minnesota Council in its efforts to aid teachers in the often challenging task of teaching economics. I call economic education a “challenging task” not just to make all of you feel special, but because we at the Federal Reserve know those challenges well. We face them, too; namely, how to explain often complicated ideas in a clear and concise manner. The Federal Open Market Committee, under the leadership of Chairman Ben Bernanke, has made communication a top goal, and as I will describe in a moment, I am on record as strongly supporting this initiative. In many respects, communication is another word for education. The better we communicate, the more we educate about the Federal Reserve’s responsibilities and its actions. And before I begin, I should remind you that my comments here tonight reflect my views alone, and not necessarily those of others in the Federal Reserve System, including my FOMC colleagues.

So speaking with teachers and the MCEE is especially rewarding to me, because you are the unsung but vital allies in the Federal Reserve System’s efforts to communicate about policy. Effective policy implementation requires public support and, therefore, public understanding. Public understanding of policy decisions, in turn, requires clear communication between policymakers and the public. In my view, the bulk of the responsibility for clear communication falls on policymakers themselves. With this in mind, I have strongly supported Federal Reserve System initiatives toward greater transparency about our decisions and the logic behind them. In my speeches, articles and video statements on our website—as well as via the Bank’s Twitter and YouTube channels, its Facebook page and its smartphone delivery system—I try to clearly outline my own thinking about policy.

Now, although policymakers have the primary responsibility for effectively communicating their decisions, the task becomes easier when the general public has a basic grasp of economic and financial principles. In my frequent dialogues with audiences in the Ninth Federal Reserve District, I am often impressed by their interest in and understanding of policy issues. Their perceptiveness bolsters my belief in the importance and possibility of clear communication about policy. Everyone benefits from a better public understanding of basic economic concepts. It helps policymakers in their efforts to successfully convey policy decisions, and it allows voters to more effectively hold policymakers accountable.

These benefits should not be taken for granted, however. They are the result of an effective system of general education that relies on elementary, secondary and college teachers to provide training in economics, personal finance and related social sciences. With that in mind, I want to express my sincere appreciation not only to the instructors who teach these concepts, but especially, in the context of MCEE’s 50th anniversary, to those who support and prepare them to teach.

More broad than deep

The objective of general economic and personal finance education is more broad than deep. In particular, it need not aim at preparing students to be professional economists, even though some of them will follow that path. I know this from experience. Despite having little exposure to economics instruction until I was a college undergraduate, I was not disadvantaged in my subsequent pursuit of an economics Ph.D. It remains the case that many successful professional economists and current economics graduate students had little formal training in economics before college or, in some cases, graduate school. In other words, the primary aim of K-12 education in economics and finance is to prepare students to be thoughtful individuals, good citizens and intelligent workers, but not necessarily economists.

These aims can be largely met by successfully conveying a small set of basic economic and finance concepts. We economists are notorious for our arguments and disagreements, of course, but the fact is we generally agree on the basic concepts that underlie economic reasoning. Fortunately, economists and economic educators have already translated these core concepts into standards for K-12 instruction, including the Voluntary National Content Standards in Economics from the MCEE’s national partner, the Council for Economic Education² and the Minnesota Department of Education’s proposed new social studies standards.³

So the good news is that these concepts and more have already been written into proposed or actual standards for K-12 social science education, and there are additional proposed and actual standards in personal finance. In other words, appropriate specific objectives for K-12 economic and personal finance education are pretty well understood.

The challenge, however, is to meet those objectives. Although parents and other mentors and nonschool experiences play an important role, especially in personal finance learning, effective K-12 teaching is critical to achieving a broad base of public understanding of basic economic and finance concepts. The mission of the MCEE and its sister organizations stems from the idea that effective teaching is based on good material and a well-prepared instructor.

The MCEE has long provided a full range of materials organized to help teachers teach to standards, including full curricula and lesson plans from the Council for Economic Education, other state councils on economic education and organizations such as Junior Achievement and the National Endowment for Financial Education. On its own, the MCEE has taken a leading role in delivering materials and hosting student competitions for the Cargill Global Food Challenge, a curriculum that teaches students how supply and demand factors interact to determine equilibrium prices and quantities in a global market while also covering policy issues related to agriculture, trade and food security. The widely used Seas, Trees, and Economies environmental economics curriculum was developed by Curt Anderson, director of the MCEE’s center at the University of Minnesota Duluth. Anderson and the MCEE are also in the process of disseminating a new set of personal finance materials. For classroom teachers developing their own materials, the MCEE provides workshops and mentoring as well as awards for outstanding new lesson plans in economics and personal finance, funded by 3M and Thrivent, respectively. Of course, one of the reasons we are here tonight is to witness the presentation of those awards, which will occur shortly.

Preparing teachers

Teaching materials are important, but only if they are taught, and especially if they are taught by a well-trained teacher. Ideally, all teachers would be trained in the content and pedagogy of their subject areas in their undergraduate or graduate courses, but the reality is that many K-12 teachers teach subjects they did not study extensively in college. When the subject is economics or personal finance, a common reaction is panic, often followed by a call for help to the MCEE or a similar organization. To meet the needs of both new and experienced teachers at all grade levels, the MCEE offers an array of courses, ranging from Using Children’s Literature to Teach Economics and Personal Finance to Enhancing the Social Studies Curriculum with Economics and Preparing to Teach High School Economics.

Scott Wolla’s story illustrates that the results can be impressive. Wolla became a social studies teacher at Hibbing (Minn.) High School in 1996. When the opportunity to teach economics opened in 2001, Wolla volunteered, but soon decided he needed help, despite having a degree in social studies education. Like many others in this situation, he turned to the MCEE for instruction on suitable materials and lessons plans. Before long, he was not only confident, but proficient. Wolla coached his students to the national championships in the Council for Economic Education’s Economics Challenge competition three times, culminating in a national championship in 2006; his students have also won the Cargill Global Food Challenge.

Wolla went on to develop his own lessons plans, winning the MCEE’s 3M Innovative Economic Educator Award in 2003. In 2006, he was named Minnesota’s high school social studies teacher of the year and won MCEE’s 3M Economic Educator Excellence award for career achievement. Along the way, Wolla completed a master’s degree in economics for educators. He now serves as one of my colleagues, as an economic education specialist at the Federal Reserve Bank of St. Louis.

The transition from panic to proficiency taken by Wolla has been repeated by many others. As those of you who attend EconFest regularly already know, a number of Wolla’s fellow recipients of the MCEE’s 3M and Thrivent Innovative Educator awards have related similar tales. But the case is backed up by research as well as anecdotes.

A recent study by Wendy Way and Karen Holden of the University of Wisconsin documents a gap in readiness to teach personal finance among K-12 educators from across the country.⁴ Almost 90 percent of the K-12 teachers who responded to Way and Holden’s survey expressed moderate to strong agreement with the idea that “students should be required to take a financial literacy course or pass a literacy test for high school graduation,” and about 30 percent had actually taught financial literacy concepts (usually integrated into a course on another or broader topic). Nonetheless, the respondents reported a large gap in knowledge about how to teach personal finance. Only 3 percent of K-12 teachers had taken a college course that covered how to teach personal finance, and just 7 percent to 11 percent felt well qualified in areas such as integrating financial literacy concepts into their disciplines, developing examples to explain financial literacy concepts and assessing students’ financial literacy understanding. These findings corroborate the anecdotes of panic that lead many new teachers of economics and personal finance to seek out the MCEE and its affiliates.

Proficient students

Research also supports the anecdotes of student proficiency achieved through teacher training on economics and personal finance pedagogy. Two scholars associated with the MCEE’s center at St. Cloud State University, Rich MacDonald and Ken Rebeck, teamed with the University of Nebraska’s William Walstad to assess how much a well-prepared teacher using a well-designed curriculum could enhance students’ acquisition of personal finance knowledge.⁵ They worked with 15 teachers in four states who were trained to use the Council for Economic Education’s Financing Your Future curriculum.

After being trained, these teachers used the curriculum to instruct hundreds of students. Those students and a control group of similar students who received no instruction were tested both before and after the instruction, and the results were clear. Before instruction began, both groups of students correctly answered just under 50 percent of the test questions. Afterward, performance was unchanged for the control group, but rose to almost 69 percent correct for the students receiving instruction, a statistically significant improvement.

In short, well-trained teachers using sound curricula make a difference. That logic lies behind the Federal Reserve Bank of Minneapolis’ long partnership with the MCEE, the Montana Council on Economic Education and other economic and personal finance education organizations. Our senior officers and economists have worked with the MCEE and others since at least the 1960s. We value the opportunities the MCEE provides for talking with K-12 educators about macroeconomics, monetary policy, financial supervision and the role of the Federal Reserve System, and their help in publicizing and building participation for our annual economic essay contest. And each April we are honored—and honestly, get a huge kick out of— hosting teams from across Minnesota in the final rounds of the MCEE’s two state high school quiz-bowl-like championships, the Economics Challenge and the Personal Finance Decathlon.

So, on behalf of the Federal Reserve Bank of Minneapolis, let me thank all of those who teach economics and personal finance as well as all those who support, prepare and train them, with a special nod to our long-term partner, the Minnesota Council on Economic Education, on the occasion of its 50th anniversary celebration this October. Let’s keep working together to prepare students to be thoughtful individuals, good citizens, intelligent workers and, sometimes, teachers and economists.

Endnotes

Thank you for that generous introduction, John. As Paul Drake described earlier, the board of directors of the Helena Branch of the Federal Reserve Bank of Minneapolis is meeting here in Sidney to commemorate John Franklin’s last meeting as a member of that board. I would like to take this opportunity to publicly thank John for his generous service to the Federal Reserve, as well as other members of the board, past and present. It is important for people to realize that the Federal Reserve is represented by dedicated citizens like John and his colleagues on all of the System’s bank and branch boards. In addition, each Federal Reserve bank has a number of advisory councils representing Main Street businesses, agricultural producers, labor groups and community banks and thrifts, among other constituencies. As I will describe later, the input from these citizens plays an important role in the development of monetary policy. So thank you, once again, to John and the rest of the Helena board of directors, as well as others in the audience who have served us so well.

I’d also like to offer congratulations, on behalf of myself and the Federal Reserve Bank of Minneapolis, to Thomas Sargent and Christopher Sims, winners of the 2011 Prize in Economic Sciences in Memory of Alfred Nobel. In the 1970s, in separate research, Sargent and Sims developed systematic approaches to distinguishing between cause and effect in macroeconomic data. Now, almost 40 years later, their thinking informs the making of macroeconomic policy around the world. I’m especially proud that much of the work recognized by the prize committee was done at the Federal Reserve Bank of Minneapolis and the University of Minnesota. My predecessors at the Federal Reserve Bank of Minneapolis deliberately fostered a research environment that could give rise to such important work, and this tradition continues today.

In the rest of my remarks today, I’d like to touch on several topics. I’ll begin with a quick description of the structure of the Federal Reserve System and the deliberative process of the Federal Open Market Committee, the Fed’s policymaking group. Then I’ll describe the FOMC’s objectives and discuss its recent performance with regard to those objectives. I’ll close with a discussion of my dissents on recent FOMC decisions. After that, I’ll be pleased to answer any questions you may have. And before I begin, I should remind you that my comments here today reflect my views alone and not necessarily those of others in the Federal Reserve System, including my FOMC colleagues.

The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and by area, we’re the second largest—thanks in no small part to the great state of Montana. Our district also includes the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the FOMC meets to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Currently, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually. Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas and Chicago Federal Reserve Banks.

I’ve said that the FOMC meets (at least) eight times per year. But how do these meetings work? At a typical meeting, there are two so-called go-rounds, in which every president and every governor has the opportunity to speak without interruption. The first of these is referred to as the economics go-round. It is kicked off by a presentation on current economic conditions by Federal Reserve staff economists. Then, the presidents and governors describe their individual views on current economic conditions and their respective outlooks for future economic conditions. The presidents typically start by providing information about their district’s local economic performance. We get that information from our research staffs, but also from our interactions with business and community leaders in industries and towns from across our districts.

The chairman speaks at the end of the first go-round. He briefly but thoroughly summarizes the preceding 16 perspectives. I can assure you that this is no easy task—and the chairman’s balanced and thoughtful treatment of our remarks is one of the many reasons that he commands such respect among his colleagues. He then provides his own views on the economy.

The Committee next turns to the second go-round, which focuses on policy. Again, the staff begins, with a presentation of policy options. After that, each of the 17 meeting participants has a chance to speak on what each views as the appropriate policy choice. This set of remarks is followed with a summary by the chairman, in which he lays out what he sees as the Committee’s consensus view for future policy. The voting members of the FOMC then cast their votes on this policy statement and thereby set monetary policy for the next six to seven weeks.

I think that this description of an FOMC meeting highlights how the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. And, as I’ve described, their input relies critically on information received from district residents. In this way, the Federal Reserve System is deliberately designed to give the residents of Main Street a voice in national monetary policy.

I’ve said that FOMC participants seek to adopt what they view as the appropriate policy choice. That provides a natural segue into my next topic: the policy objectives of the FOMC. The FOMC has a dual mandate, established by Congress: to set monetary policy so as to promote price stability and maximum employment. In my view, the heart of implementing the price stability mandate is to formulate and communicate an objective for inflation. The central bank then fulfills its price stability mandate by making choices over time so as to keep inflation close to that objective.

Of course, the central bank’s job is complicated by economic shocks that may lower or raise inflationary pressures. The central bank provides additional monetary accommodation—like lower interest rates—in response to the shocks that push down on medium-term inflation. It reduces accommodation in response to the shocks that push up on inflation. By doing so, it works to ensure that inflation stays close to its objective.

It is not enough to have an objective—the Federal Reserve must also communicate that objective clearly and credibly. That communication serves to anchor the public’s medium- and long-term inflationary expectations. Put another way, without clear communication of objectives, the public can only guess at the intentions of the FOMC, and inflationary expectations and inflation itself will inevitably end up fluctuating—and perhaps by a lot. It is possible to undo these shifts in expectations, but doing so entails significant economic cost. The nation saw this all too clearly in the early 1980s, when tighter monetary policy necessary to rein in high inflation resulted in painful employment losses.

The Federal Reserve communicates its objective for inflation in a number of ways. For example, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation five years hence, assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.”

Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. Some see an intrinsic conflict between the FOMC’s price stability mandate and maximum employment mandate. But there is actually a deep sense in which the price stability and maximum employment mandates are intertwined. Imagine that inflation runs at 3 or 4 percent per year for three or four years. The public will then start to doubt the credibility of the Fed’s stated commitment to a 2-percent-or-a-bit-under objective. The public’s medium-term inflationary expectations will consequently begin to rise. As we saw in the latter part of the 1970s, these changes in expectations can serve to reinforce and augment the upward drift in inflation. At that point, the Federal Reserve will have to tighten policy considerably if it wishes to regain control of inflation. But we learned in the early 1980s that the resultant tightening—while necessary—generates large losses in employment. In other words, failing to meet its price stability mandate can also lead the FOMC, over the medium and long term, to substantial failure on its employment mandate.²

Over the past year, the FOMC has communicated through its statements that it perceives the current unemployment rate to be elevated relative to levels that it views as consistent with its dual mandate. However, an important and ongoing communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. Changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

How has the FOMC performed relative to its dual mandate over the past three and a half years, since the onset of the Great Recession at the end of 2007? In terms of price stability, the answer is: remarkably well. The personal consumption expenditure (PCE) inflation rate has averaged 1.8 percent per year from the fourth quarter of 2007 through the second quarter of 2011. In my view, this outcome is essentially consistent with price stability.

Now, I want to be clear here about what I mean when I say “inflation.” That number I just gave you, 1.8 percent per year for more than three years, refers to what’s termed headline inflation. It includes all goods and services, including food and energy. When the Fed says that it is committed to keeping inflation at 2 percent or a little less, it means prices for all goods and services, including the gas we put in our cars and the food we put on our tables. When we make reference to year-over-year core inflation—that is, inflation without food and energy—it’s only because we believe that core inflation is a helpful predictor of headline inflation over the next three or four years.

The FOMC’s admirable performance on the price stability mandate is not due to luck. Since mid-2006, residential land prices in the United States have fallen by over 50 percent.³ Falling land prices were at the heart of the financial crisis from 2007 to 2009 and have generated a persistent fall in wealth and borrowing capacity for households. The associated declines in demand for consumption goods and investment goods pushed downward on prices and inflation.

Confronted with this enormous shock to the economy, the Federal Reserve followed an unprecedentedly and imaginatively accommodative policy. It kept interest rates near zero. It provided “forward guidance” by explicitly expressing its expectation that interest rates would stay extraordinarily low for an extended period. It bought over $2 trillion of longer-term government securities. Through these actions, the Fed provided an extraordinary amount of monetary stimulus—and so was able to meet its price stability mandate in the face of challenging circumstances.

Unemployment does remain disturbingly high—over 9 percent. However, I am sure that it would be even higher without the enormous amount of monetary stimulus being provided by the Fed. Moreover, I believe that the FOMC could only have systematically lowered the unemployment rate further by generating inflation rates over a multiyear period that were higher than its communicated objective of 2 percent. Such an outcome could potentially lead the public to lose faith in the credibility of the FOMC’s communicated objective and thereby increase the probability that the FOMC would lose control of inflation. As I discussed earlier, this scenario would require a policy response that would generate substantial losses of employment.

I want to close my discussion of FOMC performance by explaining why there is no longer an intrinsic connection between the size of the Fed’s balance sheet and inflation. I’ve mentioned how the Federal Reserve has bought over $2 trillion of government securities. It has funded that purchase by tripling the amount of deposits held by banks with the Fed—what are called bank reserves. The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are essentially licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. And if you took any economics in school you learned: more money chasing the same number of goods—voilà, inflation. Indeed, I think I’m pretty safe in saying that after four years in economics grad school, I’ve uttered this phrase—more money chasing the same number of goods creates inflation—more often than anyone else in this room.

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

I’m confident, though, that at some point in the future, the economy will improve and banks will once again have good lending opportunities. Some observers are concerned that once this happens, the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation. The Fed’s ability to pay interest on reserves means that the old and familiar link between increased bank reserves and higher inflation has been broken.

Of course, this requires the Fed to raise the interest rate on reserves in response to changes in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently timely and effective manner to keep inflation at 2 percent or a little less? But that’s always been the key question to ask about Fed policy, even when the Fed had a much smaller balance sheet. And that’s my point: Because the Fed can pay interest on reserves, the size of its balance sheet does not, in and of itself, undercut the credibility of its commitment to keep inflation at 2 percent or a bit under. I believe that’s why both survey and market-based measures of expected inflation over the next five to 10 years have remained remarkably stable as the Fed has expanded its liabilities.

Let me summarize my review of FOMC performance since the beginning of the Great Recession in December 2007. My assessment is that, despite some profound economic shocks, the FOMC—led by Chairman Bernanke—has successfully met its price stability mandate by engaging in imaginative forms of monetary accommodation. These actions have also helped lower the unemployment rate. As part of its accommodative policy, the FOMC has greatly expanded its balance sheet. But it is important to understand that this expansion need not trigger inflation now or in the future, because the Federal Reserve can now pay interest on bank reserves.

With all that said, I’ve dissented from the FOMC’s decisions in the past two meetings. As I mentioned earlier, I believe that the FOMC’s ultimate effectiveness relies critically on its communication and the credibility of that communication. I’ve dissented at the last two meetings because I believe that the Committee’s decisions at those meetings diminish that requisite credibility. I’ll close my remarks today by explaining my thinking on this matter.

The FOMC’s dual mandate, as I’ve said, is to keep inflation at 2 percent or a bit under and to promote maximum employment—that is, to keep unemployment low. Over the past few years, the Fed has quite appropriately provided a historically unprecedented level of monetary accommodation. However, as inflation rises and unemployment falls, the FOMC should respond by lowering the level of accommodation. This kind of systematic response to changes in economic conditions is an essential part of good monetary policy for at least a couple of reasons. First, there is a great deal of empirical evidence and theoretical support for the idea that following a systematic policy rule, as economists call it, is what enables the Committee to achieve its dual mandate goals. Second, and perhaps more importantly, actions speak louder than words. The Committee can claim that it intends to make monetary policy so as to fulfill its dual mandate. But the public will watch its actions carefully in this regard. If the Committee fails to reduce its immense amount of accommodation in a timely fashion, the public will begin to doubt the Committee’s claims about its goals.

In November 2010, the FOMC undertook a second round of purchases of long-term government securities—an action that has become known as QE2. This was a controversial move in some quarters, but I supported it—and I believe that it played a valuable role in reducing what seemed at the time to be a large risk of deflation. Let’s look back at economic conditions at that November 2010 meeting. The unemployment rate was 9.8 percent and was expected to be 9 percent a year later. The year-over-year core PCE inflation rate was less than 1 percent and was expected to rise to 1.3 percent over the course of 2011.

Now, fast-forward to October 2011. The unemployment rate is 9.1 percent and is expected to be near 8.5 percent by the end of 2012. The year-over-year core PCE inflation rate is 1.6 percent and is expected to stay near that level—or even higher—over the course of the coming year.⁴ So, since November 2010, the unemployment rate and the outlook for the unemployment rate have improved. Inflation and the outlook for inflation have both risen closer to 2 percent. As I’ve just discussed, in response to these changes in economic conditions, the Committee should have lowered the level of monetary accommodation over the course of the year. Instead, through actions taken at its last two meetings, the Committee has raised the level of monetary accommodation. In this sense, the Committee’s recent actions in 2011 are inconsistent with the evolution of the economic data in 2011.

I want to be clear about one additional point. Along with many private sector forecasters, the FOMC has overestimated the strength of the recovery over the past two years. Some have suggested that the unexpected slowness of the recovery is a justification for the FOMC’s increasing the level of monetary accommodation over the past couple of months. But I disagree with this argument. I’ve described how, as the economy recovers, the FOMC should respond by reducing the level of monetary accommodation. Logically, it follows that if the economy recovers more slowly than expected, then the FOMC should respond by reducing the level of monetary accommodation more slowly than expected. The FOMC should only increase accommodation if the economy’s performance, relative to the dual mandate, actually worsens over time.

To sum up: The Committee’s actions at the last two meetings are inconsistent with a systematic pursuit of its communicated objectives. It follows that these actions diminish the Committee’s credibility and so reduce the effectiveness of future Committee actions and communications. And that’s why I’ve dissented from the Committee’s actions at those meetings.

Thank you very much for your attention, and I look forward to taking your questions.

Endnotes

Sargent and Wallace published their classic “Some Unpleasant Monetarist Arithmetic” in the Minneapolis Fed’s Quarterly Review in 1981. Since that date, there has been a growing appreciation of the role of fiscal policy in the determination of the price level. The idea is a simple one. Consider a government that borrows only using non-indexed debt denominated in its own currency. There is an intertemporal government budget constraint that implies that the current real value of government liabilities—including the monetary base—must equal the present value of future real surpluses. Because the liabilities are nominal and non-indexed, the government budget constraint provides a linkage between the public’s assessment of future real tax collections and government spending and the current price level.

I like John Cochrane’s analogy here.² He thinks of money and government bonds as being like stock in a company. Just like a firm’s stock, money and bonds implicitly represent claims to the ownership of the government’s stream of surpluses. And just like with financial assets, the variations in their prices are fundamentally linked to variations in the present discounted value of government profits—that is, surpluses.³

This simple insight has rather profound consequences for how we think about inflation. Inflation is no longer “always and everywhere a monetary phenomenon.” Instead, even apparently independent central banks may not have control of the price level. Thus, if the public begins to think that the fiscal authority is behaving irresponsibly, that belief will push upward on the price level.

However, in the existing literature, the analysis of fiscal effects on the price level is typically based on the presumption that a fiscal authority will never default on liabilities denominated in its own currency. In my remarks today, I will relax this assumption. Once I do so, it will become clear that a sufficiently tough central bank does have the ability to control the price level, regardless of the behavior of the fiscal authority.⁴ I will argue that its ability to do so hinges on the nature of its response to the possibility of default on the part of the fiscal authority. I will talk about some of the short-run versus long-run tensions involved in that response. Throughout, I will refer to the central bank as CB and the fiscal authority as FA. I will refer to the currency as being dollars, but that should not be viewed as suggesting that I am talking about the United States—or Australia.

Let me start by describing a simple CB policy: a commodity price peg. Suppose the central bank holds X ounces of gold. It commits to being willing to buy and sell p dollars for each ounce of gold and has a monetary base of $pX. This policy successfully ties the price level to variations in the price of gold, regardless of the behavior of the FA.

What impact does this policy have on the FA? Now, when the FA borrows in dollars, it is essentially borrowing in a real commodity: gold. All of the FA’s debt is essentially indexed to the price of gold, and it is certainly conceivable that various shocks could lead the FA to default on those obligations.⁵

Of course, as I have argued elsewhere, this simple policy is generally viewed as suboptimal by macroeconomists.⁶In contrast, suppose that the CB follows an aggressive Taylor rule when determining the path of the short-term interest rate.⁷ That policy pins down an inflation path in the usual way, regardless of the FA’s fiscal plans.⁸ However, given that inflation path, the FA’s nominal debt is now actually real. This means that if the FA is faced with an unexpected decline in its current and expected future real surpluses, it will be forced to default.

Thus, once we allow for the possibility of default by the FA, a sufficiently tough CB can have considerable control over the price level. Of course, I’ve been arguing through examples. It would be more interesting to deliver a fuller characterization of the term “sufficiently tough”—but I’m not going to attempt to do so. Instead, in what follows, I’ll discuss some aspects of the CB’s response to a particularly critical situation.

Suppose the FA owes $10 billion on a given Friday. It plans to repay that loan by auctioning new debt on the preceding Monday. However, when it auctions off the new debt, it finds that it can only raise $5 billion. The FA is now in danger of defaulting on its Friday obligation of $10 billion.

It is at this stage that the level of commitment of the CB to its chosen inflation path will be severely tested. The FA will ask the CB to take some action that will allow the FA to raise an additional $5 billion on Wednesday. There are many possible actions. The FA might ask the CB to intervene by setting a floor on the price of debt in the Wednesday auction. But there are less overt approaches. For example, the CB can commit to a price peg for the FA’s debt in the secondary market for that debt.

In any event, if the CB does intervene in some way to ensure the FA’s solvency, the CB no longer can be said to have independent control over the price level. If the CB’s intervention was largely unanticipated by markets, expected inflation will rise after the CB’s intervention. Then, incipient fiscal insolvency has triggered inflationary pressures. Of course, markets may well have already assigned a positive probability to the possibility that the CB might intervene in this kind of scenario. If so, then past inflation was already influenced by the markets’ expectations of this fiscal policy scenario.

Should the CB be required to never intervene in this sort of insolvency scenario? I’ve argued that a ban on these interventions will give the CB more independence in its control over the price level. For those who think of CB independence as being the foundational element of macroeconomic policy, that pretty much settles the question.

But I see a couple of reasons for caution here. It is certainly conceivable that FA insolvency can be triggered by shocks that are well outside the control of the FA itself. And, empirically, FA insolvency is associated with large short-term and even medium-term declines in output. Should the CB be prepared to drive the FA into insolvency given the possible adverse economic impact on the country?

More subtly, regardless of the FA’s solvency, sovereign debt issues can fail simply through a coordination failure among investors. If I, as an investor, don’t anticipate that others will buy into the debt issue, I won’t either. In this sense, sovereign debt issues may be susceptible to suboptimal “runs.” The CB can eliminate this possibility by ensuring the nominal promises of the FA whenever the FA is threatened with default.

Thus, I see trade-offs. On the one hand, if the CB is known to be willing to intervene to keep the FA solvent, then inflation is necessarily shaped by fiscal considerations and by the short-run incentives of elected officials. We know from many years of theoretical and empirical research that this effect is not a desirable one. On the other hand, if the CB is fully committed to allow the FA to default if necessary, then even optimal debt management by the FA may end up exposing the country to troubling risks, like sovereign debt runs.

Let me wrap up. I’ve argued that even if the fiscal authority borrows exclusively in its country’s own currency, the central bank can have a large amount of control over the price level. But the central bank can only achieve that control if it is willing to commit to letting the fiscal authority default. Such a commitment may expose the country to risks of short-term and medium-term output losses. How this trade-off should best be resolved awaits future research. But it may turn out to be optimal for central banks to guarantee fiscal authority debts in some situations. If so, we again have to think of price level determination as something that is done jointly by the fiscal authority and the central bank—just as Sargent and Wallace taught us 30 years ago.

Endnotes

References

Atkeson, Andrew, V. V. Chari and Patrick J. Kehoe. 2010. “Sophisticated Monetary Policies.” Quarterly Journal of Economics 125, 47-89.

Bassetto, Marco. 2008. “Fiscal Theory of the Price Level,” in Lawrence Blume and Steven Durlauf (eds.), New Palgrave: A Dictionary of Economics, 2nd edition.MacMillan: London.

Cochrane, John H. 2005. “Money as Stock.” Journal of Monetary Economics 52, 501-28.

Cochrane, John H. 2011. “Determinacy and Identification with Taylor Rules.” Working paper. University of Chicago, Booth School of Business.

Eaton, Jonathan, and Mark Gersovitz. 1987. “Country Risk and the Organization of International Capital Transfer.” NBER Working Paper 2204, April.

Kocherlakota, Narayana. 2011. “It’s a Wonderful Fed.” Speech, St. Paul, Minn.

Sargent, Thomas, and Neil Wallace. 1981. “Some Unpleasant Monetarist Arithmetic.” Federal Reserve Bank of Minneapolis Quarterly Review, Fall, 1-17.

One of my jobs as president of the Federal Reserve Bank of Minneapolis is to help in the formulation of monetary policy. The Federal Open Market Committee—the FOMC—meets eight times per year to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Actually, right now, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a group of four other presidents that rotates annually (currently Minneapolis, Philadelphia, Dallas and Chicago). As I said, the Committee meets eight times per year. Its deliberations concern the appropriate readjustment of monetary policy to the new information received since the last meeting. But the Committee has to keep in mind its medium-term and indeed long-term goals when making those readjustments. And it must also keep in mind the public’s understanding of those goals.

This perspective—that good policy responds to the current conditions so as to achieve certain well-communicated future goals—will be a key theme for the remainder of my remarks. They will be divided into three parts. The first part is about the FOMC’s objectives and my thoughts regarding them. In the second part, I discuss the FOMC’s performance relative to those goals in the past three and a half years since the beginning of the Great Recession. Finally, I close with an analysis of recent FOMC decision-making. Here, my discussion is perhaps a little more disengaged than usual, since I dissented from—that is, formally disagreed with—the last FOMC decision. And here it seems especially à propos to remind you that my remarks here today reflect my thoughts alone, and not necessarily those of others in the Federal Reserve System, including my colleagues on the Federal Open Market Committee.

FOMC Objectives

Let me turn first to a discussion of FOMC objectives. Congress has mandated that the Federal Reserve set monetary policy so as to promote price stability and maximum employment. In my view, the heart of implementing the price stability mandate is to formulate and communicate an objective for inflation. The central bank then fulfills its price stability mandate by making choices over time so as to keep inflation close to that objective. Of course, the central bank’s job is complicated by economic shocks that may lower or raise inflationary pressures. The central bank provides additional monetary accommodation—like lower interest rates—in response to the shocks that push down on inflation. It reduces accommodation in response to the shocks that push up on inflation. By doing so, it works to ensure that inflation stays close to its objective.

As I said, though, it is not enough to have an objective—the Federal Reserve must also communicate that objective clearly. That communication serves to anchor medium- and long-term inflationary expectations. Put another way, without clear communication of objectives, the public can only guess at the intentions of the FOMC. Inflationary expectations and inflation itself will inevitably end up fluctuating—and possibly by a lot. As I’ll discuss later, it is possible to undo these shifts in expectations, but only at significant economic cost.

The Federal Reserve communicates its objective for inflation in a number of ways. For example, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation five years hence, assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.” But the Fed has also communicated its intentions more directly and more broadly. Last December, for example, on the television program “60 Minutes,” Chairman Bernanke explained the dangers of letting inflation fall too low relative to this 2-percent-or-a-bit-under range. In the same interview, he also emphasized that the FOMC is unwilling to allow inflation to rise above this range.²

As I’ll describe in more detail later in my speech, the economy was hit in the past three and a half years by shocks that had the potential to drive inflation significantly downward. I believe that the FOMC’s clear communication of its inflation objective has helped the FOMC keep inflation from falling too low in the face of those shocks. At the same time, clear communication of its objective has also allowed the FOMC to follow highly accommodative monetary policies—like keeping interest rates near zero for nearly three years—without triggering large upward movements in inflationary expectations.

I’ve been emphasizing the importance of communication—and communication matters greatly. But, ultimately, the public’s beliefs about the FOMC’s inflation objective will also depend on inflationary outcomes. If annual inflation averages less than 1.5 percent for more than three or four years, onlookers will begin to suspect that the FOMC’s true objective for inflation is lower than its declared “two percent or a bit under.” Correspondingly, if inflation is persistently higher than 2 percent, then the public will begin to believe that the FOMC’s true objective for inflation is higher than 2 percent. In either case, inflation expectations could become unmoored, and the FOMC could lose control of inflation itself. Communication can only be effective if the FOMC also retains credibility.

As I mentioned, Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. In the past, some have seen an intrinsic conflict between the FOMC’s price stability mandate and its maximum employment mandate. In contrast, my thinking accords with the more modern viewpoint that there is relatively little tension between these two goals. The modern paradigm recognizes that monetary policy should allow the natural supply-and-demand forces in the economy to operate without impediment. For example, if energy costs spike, the basic forces of supply and demand dictate that firms will cut back on production and demand less labor, creating higher unemployment. It is inefficient for any policy—including monetary policy—to attempt to interfere with this natural adjustment process. It follows that the Federal Reserve’s operational definition of “maximum employment” has to vary over time.

Nonetheless, the modern paradigm does view price stability as playing a crucial role in ensuring maximum employment. It is well-documented that different firms adjust their prices at different times and in different ways in response to the ebb and flow of inflationary pressures in the economy. This asynchronous adjustment of prices across firms generates economic inefficiencies, including losses of employment. By ensuring that prices follow a steady, well-understood path, the Federal Reserve eliminates the variation in inflationary pressures and the need for firms to respond to that variation. In this way, the Federal Reserve’s mission of achieving price stability is entirely consistent with its mission of achieving maximum employment.³

But there is another, deeper sense in which the price stability and maximum employment mandates are intertwined. Imagine that inflation runs at 3 or 4 percent per year for three or four years. The public will then start to doubt the credibility of the Fed’s stated commitment to a 2-percent-or-a-bit-under objective. The public’s medium-term inflationary expectations will consequently begin to rise. As we saw in the latter part of the 1970s, these changes in expectations can serve to reinforce and augment the upward drift in inflation. At that point, the Federal Reserve will have to tighten policy considerably if it wishes to regain control of inflation. But we learned in the early 1980s that the resultant tightening—while necessary—generates large losses in employment. In other words, failing to meet its price stability mandate can also lead the FOMC, over the medium and long term, to substantial failure on its employment mandate.⁴

An important communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. I’ve already talked about how a change in energy costs can push down on maximum employment. But changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

Monetary Policy since the Great Recession

As I discussed earlier, the Federal Reserve is mandated to set policies that promote price stability. With that in mind, how has the Federal Reserve done in terms of its price stability mandate since the Great Recession began in December 2007? The answer is: remarkably well. The personal consumption expenditure (PCE) inflation rate has averaged 1.8 percent per year from the fourth quarter of 2007 through the second quarter of 2011. I would say that this outcome is essentially consistent with price stability.

This admirable performance is not due to luck. Since mid-2006, residential land prices have fallen by over 50 percent.⁵ Falling land prices were at the heart of the financial crisis from 2007 to 2009 and have generated a persistent fall in wealth and borrowing capacity for households. The associated declines in demand for consumption goods and investment goods pushed downward on prices and inflation.

Confronted with this enormous shock to the economy, the Federal Reserve has followed an unprecedentedly and imaginatively accommodative policy. It has kept interest rates near zero. It has provided “forward guidance” by explicitly expressing its expectation that interest rates would stay extraordinarily low for an extended period. It has bought over $2 trillion of longer-term government securities. Through these actions, the Fed has provided an extraordinary amount of monetary stimulus—and so has been able to meet its price stability mandate.

But what about the future? There are a number of ways to measure inflationary expectations, which all—unfortunately—come with caveats. Last December, a Cleveland Fed study analyzed several such measures.⁶ It concluded that the Survey of Professional Forecasters’ (SPF’s) projections⁷ tend to forecast relatively well. The most recent SPF survey (conducted before the August FOMC meeting) predicted that PCE inflation would average 2.1 percent per year for the next five years.

Thus, in the face of challenging circumstances, the Federal Reserve has met its price stability mandate and is expected to continue to do so. Unemployment does remain disturbingly high. Yet, I am sure it would be even higher without the enormous amount of monetary stimulus that the FOMC has provided. Moreover, I believe that the FOMC could only have systematically lowered the unemployment rate further by generating inflation rates higher than 2 percent over a multiyear period. Such an outcome could well lead the public to lose faith in the credibility of the FOMC’s inflation objective and thereby increase the probability that the FOMC would lose control of inflation. As I stressed earlier, this scenario would require a policy response that would generate substantial losses of employment.

Recent FOMC Decisions

Much of my discussion so far has been a look back over the past three and a half years, since the start of the Great Recession in December 2007. My assessment is that, despite some profound economic shocks, the FOMC—led by Chairman Bernanke—has successfully met its price stability mandate by engaging in imaginative forms of monetary accommodation and thereby helped lower the unemployment rate. Now I’d like to turn to my assessment of the most recent round of FOMC decision-making. To put this part of my talk in the proper context, I want to ask another key question: How did the FOMC achieve its success over the past three and a half years with regard to price stability?

The answer, I believe, is that the FOMC consistently made choices in response to changes in short-term economic conditions that were designed to support its medium-term objectives. Getting these choices right is certainly more of an art than a science. With that said, economists have suggested a number of rules that tell central banks how to respond to changes in economic conditions so as to keep inflation near some target level. I generally find these rules useful in guiding policymaking, and especially so when they arrive at the same recommendation. (Unfortunately, that’s not always the case.)

But here’s one instance in which most of the rules do deliver the same recommended course of action. Suppose the FOMC observes an increase in available measures of inflationary pressures and a decrease in labor market slack—that is, the gap between maximum employment and observed employment. Then many monetary policy rules would recommend that the FOMC not ease policy further and in fact consider reducing the level of monetary policy accommodation. That recommendation—don’t ease further if you’re doing better on your mandates—makes sense to me.

With that recommendation in mind, let’s go back to November 2010. At that date, the FOMC took a significant policy step by announcing its intention to buy $600 billion of longer-term Treasury securities. Until the most recent meeting in August, this was the last major policy step undertaken by the Committee. What did available measures of inflationary pressures and labor market slack—the “mandate dashboard”—look like back in November?

In terms of inflation, I generally think that core inflation does a better job of tracking underlying inflationary pressures, because it does not include the highly volatile and transitory fluctuations in food and energy prices. In November, PCE core inflation over the preceding 12 months had been less than 1 percent and had decelerated throughout the year. Of course, a good mandate dashboard should also include some measure of the future course of inflationary pressures. Here, it is worth noting that, even with the large-scale asset purchase in place, FOMC participants expected core inflation to remain very low: less than 1.3 percent over the upcoming calendar year of 2011.

In terms of labor market slack, I’ve argued elsewhere that it’s hard to find reliable measures of this key variable.⁸ But the FOMC statement makes specific reference to the unemployment rate as a gauge of labor market slack, and so I’ll use that measure on my notional mandate dashboard. The unemployment rate was 9.8 percent in November 2010. With the help of the large-scale asset purchase, FOMC participants expected it to fall to about 9 percent a year hence.

How had the mandate dashboard changed in August 2011? PCE core inflation rose sharply: From December 2010 through July 2011, the annualized core PCE inflation rate was over 2 percent. FOMC participants did not submit forecasts of core PCE inflation in August. However, the most recent Survey of Professional Forecasters, done before the August FOMC meeting, predicted that core PCE inflation will average 1.7 percent in 2011 and 1.6 percent in 2012. It seems clear that inflationary pressures were higher in August than in November. My own current forecast for core PCE inflation is even higher than the SPF’s—I expect that it will average around 2 percent per year over 2011 and 2012.

What about labor market slack? The unemployment rate was 9.1 percent in August 2011, as opposed to 9.8 percent in November 2010. Again, we don’t have FOMC participant projections available from the August meeting. However, the Survey of Professional Forecasters predicts that unemployment will be 8.6 percent in just over a year’s time. Going into the August FOMC meeting, my own forecast for unemployment was a little more optimistic, in the sense that I do expect unemployment to be under 8.5 percent by the end of next year. But, even with the more pessimistic SPF forecast, labor market slack is smaller than in November 2010, when the FOMC expected unemployment to remain around 9 percent in a year’s time.

So, measures of past and forecasts of future inflationary pressures were higher in August than at the time of the FOMC’s last major policy move in November. Measures of current labor market slack and expectations of future labor market slack were smaller in August. The monetary policy rules that I described earlier would suggest, again, “Don’t ease further if you’re doing better on your mandates.” Indeed, they’d recommend that the level of policy accommodation be reduced.

Instead, at its August meeting, the FOMC decided to adopt a more accommodative policy stance. From March 2009 through June 2011, the FOMC statement said that the Committee expected to keep interest rates extraordinarily low for an “extended period,” which was generally interpreted as meaning “at least for two or three meetings.” In August 2011, the FOMC changed its statement to say that it now expected to keep interest rates extraordinarily low for at least 16 meetings. Given what I’ve said, it is not surprising that I dissented from this decision.

I would be remiss if I did not mention one subtlety in my discussion of changes in the mandate dashboard since November 2010. I’ve treated the decline in the unemployment rate as representing a decline in labor market slack. This view is not uncontroversial. From an accounting perspective, the unemployment rate can fall for two reasons: People can find jobs, or people can stop searching for jobs. Much of the decline since November is attributable to people who were formerly unemployed choosing to no longer look for work.

Nonetheless, it still seems appropriate to me to view this change in labor market conditions as representing a decline in labor market slack. Intuitively, people who are non-employed, but not actively looking for work, are less likely to apply for any given job opening. Hence, the recent departures from the labor force imply that there is less downward pressure on wages. Almost by definition, from an economic perspective, this means that there is less slack in the labor market.

The rise in core inflation in the first part of the year is consistent with the view that labor market slack has fallen. But some observers argue that core PCE inflation is only temporarily high because of the tragic events in Japan or transitory spikes in commodity prices. If so, the disinflationary pressures of 2010 should soon reappear in the form of a sharp decline in current and expected core PCE inflation rates. In that eventuality, increasing policy accommodation might well be appropriate.

I’ve argued here that the Committee increased the level of accommodation when standard rules seem to call for standing pat or even reducing accommodation. What are the costs of such a move? The standard rules are meant to guide the economy toward the Committee’s medium-term objectives. If monetary policy is consistently overly accommodative relative to these rules, the Committee risks generating inflation higher than 2 percent for several years. As I’ve discussed, such an outcome could have significant consequences for inflation and inflation expectations. Future Committees might have to endure large losses in employment in order to fix these consequences.

Conclusion

I mentioned that I dissented from the Committee’s last decision in August. Two other presidents dissented—and there have not been as many dissents at one meeting in nearly 20 years. In my view, this level of disagreement reflects two aspects of the current setting. The first is related to the leadership of the Committee. Chairman Bernanke strongly welcomes the airing of disparate views within the meeting. He clearly believes—as I do—that the United States has a decentralized central bank because we will get better monetary policy if decision-making is grounded in a wide range of views. I think that the Chairman should be applauded for this approach to policymaking.

The second is related to the nature of the economic data that we’ve seen in the first part of this year. I’ve described how inflation rose and unemployment fell. It’s also true that real GDP grew at less than 1 percent at an annualized rate in the first half of the year. And the outlook for real GDP growth has slipped too. Last November, my forecast for annual real GDP growth was similar to that of other FOMC participants: I expected that real GDP growth would average above 3 percent per year, and probably closer to 3.5 percent per year, over the following two years (that is, from the fourth quarter of 2010 through the fourth quarter of 2012). Now, I expect that real GDP growth will average around 2.5 percent per year over that same period of time.

It’s unusual to see an increase in inflation and a fall in unemployment occur when GDP growth is so sluggish and when the outlook for real GDP growth has slipped so much. It is hardly surprising that there might well be some disagreement about the appropriate monetary policy response to this conflicting mix of information.

My theme in this speech has been that monetary policy must have three elements if it is to implement the price stability and maximum employment mandates successfully. The FOMC needs to formulate an objective for inflation. It needs to communicate that objective effectively. And, most importantly, it needs to ensure the credibility of that communication by responding to macroeconomic conditions so as to ensure that inflation stays close to its announced objective. Losing that credibility would represent a substantial failure on the Federal Reserve’s price stability mandate and would also likely lead to substantial failures on the Federal Reserve’s maximum employment mandate.

Despite challenging circumstances, the FOMC has succeeded on all three elements over the past three and a half years. However, as I’ve argued today, the Committee’s decision in August to make monetary policy more accommodative is inconsistent with its declared intention to keep inflation at 2 percent or a bit under. Unfortunately, the FOMC’s two-year conditional commitment will be nearly impossible to undo in the near term. If the FOMC were to backtrack rapidly on this provision, it would significantly undercut the credibility of all forward guidance in the future. For that reason, I plan to abide by the conditional commitment of August 2011 in thinking about my own future decisions.

However, as was indicated in the recently released minutes of the August FOMC meeting, participants discussed the possibility of adopting alternative and/or additional forms of accommodation. My understanding is that this discussion will continue at our two-day September meeting. In a speech last week in Bismarck, I said that I believe that any additional provision of accommodation in September or thereafter will have to be judged on its own merits. Some readers or listeners may have found this statement to be imprecise. So, let me elaborate on what I meant then, and continue to believe. I assess FOMC actions in light of the incoming data and the Committee’s communicated objective of keeping inflation at 2 percent or a bit under. With that in mind, the data in August did not justify the additional accommodation provided at that meeting. It is unlikely that the data in September will warrant adding still more accommodation.

Thanks for your attention. I’m happy to take your questions.

Endnotes

References

Blanchard, Olivier J., and Jordi Galí. 2007. “Real Wage Rigidities and the New Keynesian Model.” Journal of Money, Credit and Banking Supplement 39, pp. 35-65.

Kocherlakota, Narayana. 2011. “Labor Markets and Monetary Policy.” 2010 Annual Report. Federal Reserve Bank of Minneapolis.

Justiniano, Alejandro, Giorgio E. Primiceri and Andrea Tambalotti. 2011. “Is There a Trade-Off Between Inflation and Output Stabilization?”

Meyer, Brent H., and Mehmet Pasaogullari. 2010. “Simple Ways to Forecast Inflation: What Works Best?”

One of the aspects of my job that I enjoy most is the opportunity to visit communities across the Ninth District. I have had the pleasure of traveling to each state in the district in my nearly two years as president, but this is my first trip to Bismarck in that time. I want to express my thanks to the National Association of State Treasurers for this invitation. I also want to extend my thanks to the area business and civic leaders who have taken time from their busy schedules to meet with me today to discuss the area’s economic conditions, as well as those who will join me later this afternoon to tour areas hit by this year’s Missouri River flooding.

The flooding experienced by North Dakota communities—most notably along the Missouri and Souris rivers, but also along other state waterways—has dealt an unfortunate economic setback to many cities in a state that has otherwise experienced very good economic outcomes in recent years. We have been monitoring the economic impact of the 2011 floods at the Federal Reserve Bank of Minneapolis and will continue to do so, in North Dakota as well as Montana and South Dakota. It will be some time before we have a complete reckoning of all associated costs.

However, one thing seems certain: The same cooperative attitude and resilience that has characterized communities’ responses to the flooding suggests that their recovery will be a strong one. In his History of North Dakota, Elwyn B. Robinson cites a late-19th century British statesman, who described the prevailing spirit of optimism of the people who settled west of the Mississippi River: “Men seem to live in the future rather than in the present: not that they fail to work while it is called for to-day, but they see the country not merely as it is, but as it will be, twenty, fifty, a hundred years hence.”²

I’m reasonably confident that Mr. Robinson would view this as an awkward segue, but his quote is also instructive to the operations of monetary policy. The Federal Open Market Committee—the FOMC—meets eight times per year to set the path of monetary policy over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board, including Chairman Bernanke, contribute to these deliberations. (Actually, right now, there are only five governors—two positions are unfilled.) However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents (currently Minneapolis, Philadelphia, Dallas and Chicago).

As I said, the Committee meets eight times per year. Its deliberations concern the appropriate readjustment of monetary policy to the new information received since the last meeting. But, as was true of the early settlers of our great continent, the Committee has to keep in mind its medium-term and indeed long-term goals when making those readjustments. And it must also keep in mind the public’s understanding of those goals.

This perspective—that good policy responds to the current conditions so as to achieve certain well-communicated future goals—will be a key theme for the remainder of my remarks. They will be divided into three parts. The first part is about the FOMC’s objectives and my thoughts regarding them. In the second part, I discuss the FOMC’s performance relative to those goals in the past three and a half years since the beginning of the Great Recession. Finally, I close with an analysis of recent FOMC decision-making. Here, my discussion is perhaps a little more disengaged than usual, since I dissented from—that is, formally disagreed with—the last FOMC decision. And here it seems especially à propos to remind you that my remarks here today reflect my thoughts alone, and not necessarily those of others in the Federal Reserve System, including my colleagues on the Federal Open Market Committee.

FOMC Objectives

Let me turn first to a discussion of FOMC objectives. Congress has mandated that the Federal Reserve set monetary policy so as to promote price stability and maximum employment. In my view, the heart of implementing the price stability mandate is to formulate and communicate an objective for inflation. The central bank then fulfills its price stability mandate by making choices over time so as to keep inflation close to that objective. Of course, the central bank’s job is complicated by economic shocks that may lower or raise inflationary pressures. The central bank provides additional monetary accommodation—like lower interest rates—in response to the shocks that push down on inflation. It reduces accommodation in response to the shocks that push up on inflation. By doing so, it works to ensure that inflation stays close to its objective.

As I said, though, it is not enough to have an objective—the Federal Reserve must also communicate that objective clearly. That communication serves to anchor medium- and long-term inflationary expectations. Put another way, without clear communication of objectives, the public can only guess at the intentions of the FOMC. Inflationary expectations and inflation itself will inevitably end up fluctuating—and possibly by a lot. As I’ll discuss later, it is possible to undo these shifts in expectations, but only at significant economic cost.

The Federal Reserve communicates its objective for inflation in a number of ways. For example, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for inflation five years hence, assuming that monetary policy is optimal. Those forecasts usually range between 1.5 percent and 2 percent per year. They are often collectively referred to by saying that the Federal Reserve views inflation as being “mandate-consistent” if it is running at “2 percent or a bit under.” But the Fed has also communicated its intentions more directly and more broadly. Last December, for example, on the television program “60 Minutes,” Chairman Bernanke explained the dangers of letting inflation fall too low relative to this 2-percent-or-a-bit-under range. In the same interview, he also emphasized that the FOMC is unwilling to allow inflation to rise above this range.³

As I’ll describe in more detail later in my speech, the economy was hit in the past three and a half years by shocks that had the potential to drive inflation significantly downward. I believe that the FOMC’s clear communication of its inflation objective has helped the FOMC keep inflation from falling too low in the face of those shocks. At the same time, clear communication of its objective has also allowed the FOMC to follow highly accommodative monetary policies—like keeping interest rates near zero for nearly three years—without triggering large upward movements in inflationary expectations.

I’ve been emphasizing the importance of communication—and communication matters greatly. But, ultimately, the public’s beliefs about the FOMC’s inflation objective will also depend on inflationary outcomes. If annual inflation averages less than 1.5 percent for more than three or four years, onlookers will begin to suspect that the FOMC’s true objective for inflation is lower than its declared “two percent or a bit under.” Correspondingly, if inflation is persistently higher than 2 percent, then the public will begin to believe that the FOMC’s true objective for inflation is higher than 2 percent. In either case, inflation expectations could become unmoored, and the FOMC could lose control of inflation itself. Communication can only be effective if the FOMC also retains credibility.

As I mentioned, Congress has also mandated that the FOMC set monetary policy so as to promote maximum employment. In the past, some have seen an intrinsic conflict between the FOMC’s price stability mandate and its maximum employment mandate. In contrast, my thinking accords with the more modern viewpoint that there is relatively little tension between these two goals. The modern paradigm recognizes that monetary policy should allow the natural supply-and-demand forces in the economy to operate without impediment. For example, if energy costs spike, the basic forces of supply and demand dictate that firms will cut back on production and demand less labor, creating higher unemployment. It is inefficient for any policy—including monetary policy—to attempt to interfere with this natural adjustment process. It follows that the Federal Reserve’s operational definition of “maximum employment” has to vary over time.

Nonetheless, the modern paradigm does view price stability as playing a crucial role in ensuring maximum employment. It is well-documented that different firms adjust their prices at different times and in different ways in response to the ebb and flow of inflationary pressures in the economy. This asynchronous adjustment of prices across firms generates economic inefficiencies, including losses of employment. By ensuring that prices follow a steady, well-understood path, the Federal Reserve eliminates the variation in inflationary pressures and the need for firms to respond to that variation. In this way, the Federal Reserve’s mission of achieving price stability is entirely consistent with its mission of achieving maximum employment.⁴

But there is another, deeper sense in which the price stability and maximum employment mandates are intertwined. Imagine that inflation runs at 3 or 4 percent per year for three or four years. The public will then start to doubt the credibility of the Fed’s stated commitment to a 2-percent-or-a-bit-under objective. The public’s medium-term inflationary expectations will consequently begin to rise. As we saw in the latter part of the 1970s, these changes in expectations can serve to reinforce and augment the upward drift in inflation. At that point, the Federal Reserve will have to tighten policy considerably if it wishes to regain control of inflation. But we learned in the early 1980s that the resultant tightening—while necessary—generates large losses in employment. In other words, failing to meet its price stability mandate can also lead the FOMC, over the medium and long term, to substantial failure on its employment mandate.⁵

An important communications challenge for the FOMC is that it is much harder to quantify the maximum employment mandate than the price stability mandate. I’ve already talked about how a change in energy costs can push down on maximum employment. But changes in minimum wage policy, demography, taxes and regulations, technological productivity, job market efficiency, unemployment insurance benefits, entrepreneurial credit access and social norms all influence what we might consider “maximum employment.” Trying to offset these changes in the economy with monetary policy can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.

Monetary Policy since the Great Recession

As I discussed earlier, the Federal Reserve is mandated to set policies that promote price stability. With that in mind, how has the Federal Reserve done in terms of its price stability mandate since the Great Recession began in December 2007? The answer is: remarkably well. The personal consumption expenditure (PCE) inflation rate has averaged 1.8 percent per year from the fourth quarter of 2007 through the second quarter of 2011. I would say that this outcome is essentially consistent with price stability.

This admirable performance is not due to luck. Since mid-2006, residential land prices have fallen by over 50 percent.⁶ Falling land prices were at the heart of the financial crisis from 2007 to 2009 and have generated a persistent fall in wealth and borrowing capacity for households. The associated declines in demand for consumption goods and investment goods pushed downward on prices and inflation.

Confronted with this enormous shock to the economy, the Federal Reserve has followed an unprecedentedly and imaginatively accommodative policy. It has kept interest rates near zero. It has provided “forward guidance” by explicitly expressing its expectation that interest rates would stay extraordinarily low for an extended period. It has bought over 2 trillion dollars of longer-term government securities. Through these actions, the Fed has provided an extraordinary amount of monetary stimulus—and so has been able to meet its price stability mandate. But what about the future? There are a number of ways to measure inflationary expectations, which all—unfortunately—come with caveats. Last December, a Cleveland Fed study analyzed several such measures.⁷ It concluded that the Survey of Professional Forecasters’ (SPF’s) projections⁸ tend to forecast relatively well. The most recent SPF survey (conducted before the August FOMC meeting) predicted that PCE inflation would average 2.1 percent per year for the next five years.

Thus, in the face of challenging circumstances, the Federal Reserve has met its price stability mandate and is expected to continue to do so. Unemployment does remain disturbingly high. Yet, I am sure it would be even higher without the enormous amount of monetary stimulus that the FOMC has provided. Moreover, I believe that the FOMC could only have systematically lowered the unemployment rate further by generating inflation rates higher than 2 percent over a multiyear period. Such an outcome could well lead the public to lose faith in the credibility of the FOMC’s inflation objective and thereby increase the probability that the FOMC would lose control of inflation. As I stressed earlier, this scenario would require a policy response that would generate substantial losses of employment.

Recent FOMC Decisions

Much of my discussion so far has been a look back over the past three and a half years, since the start of the Great Recession in December 2007. My assessment is that, despite some profound economic shocks, the FOMC—led by Chairman Bernanke—has successfully met its price stability mandate by engaging in imaginative forms of monetary accommodation and thereby helped lower the unemployment rate. Now I’d like to turn to my assessment of the most recent round of FOMC decision-making. To put this part of my talk in the proper context, I want to ask another key question: How did the FOMC achieve its success over the past three and a half years with regard to price stability?

The answer, I believe, is that the FOMC consistently made choices in response to changes in short-term economic conditions that were designed to support its medium-term objectives. Getting these choices right is certainly more of an art than a science. With that said, economists have suggested a number of rules that tell central banks how to respond to changes in economic conditions so as to keep inflation near some target level. I generally find these rules useful in guiding policymaking, and especially so when they arrive at the same recommendation. (Unfortunately, that’s not always the case.)

But here’s one instance in which most of the rules do deliver the same recommended course of action. Suppose the FOMC observes an increase in available measures of inflationary pressures and a decrease in labor market slack—that is, the gap between maximum employment and observed employment. Then many monetary policy rules would recommend that the FOMC not ease policy further and in fact consider reducing the level of monetary policy accommodation. That recommendation—don’t ease further if you’re doing better on your mandates—makes sense to me.

With that recommendation in mind, let’s go back to November 2010. At that date, the FOMC took a significant policy step by announcing its intention to buy $600 billion of longer-term Treasury securities. Until the most recent meeting in August, this was the last major policy step undertaken by the Committee. What did available measures of inflationary pressures and labor market slack—the “mandate dashboard”—look like back in November?

In terms of inflation, I generally think that core inflation does a better job of tracking underlying inflationary pressures, because it does not include the highly volatile and transitory fluctuations in food and energy prices. In November, PCE core inflation over the preceding 12 months had been less than 1 percent and had decelerated throughout the year. Of course, a good mandate dashboard should also include some measure of the future course of inflationary pressures. Here, it is worth noting that, even with the large-scale asset purchase in place, FOMC participants expected core inflation to remain very low: less than 1.3 percent over the upcoming calendar year of 2011.

In terms of labor market slack, I’ve argued elsewhere that it’s hard to find reliable measures of this key variable.⁹ But the FOMC statement makes specific reference to the unemployment rate as a gauge of labor market slack, and so I’ll use that measure on my notional mandate dashboard. The unemployment rate was 9.8 percent in November 2010. With the help of the large-scale asset purchase, FOMC participants expected it to fall to about 9 percent a year hence.

How had the mandate dashboard changed in August 2011? PCE core inflation rose sharply: From December 2010 through July 2011, the annualized core PCE inflation rate was over 2 percent. FOMC participants did not submit forecasts of core PCE inflation in August. However, the most recent Survey of Professional Forecasters, done before the August FOMC meeting, predicted that core PCE inflation will average 1.7 percent in 2011 and 1.6 percent in 2012. It seems clear that inflationary pressures were higher in August than in November. My own current forecast for core PCE inflation is even higher than the SPF’s—I expect that it will average around 2 percent per year over 2011 and 2012.

What about labor market slack? The unemployment rate was 9.1 percent in July 2011, as opposed to 9.8 percent in November 2010. Again, we don’t have FOMC participant projections available from the August meeting. However, the Survey of Professional Forecasters predicts that unemployment will be 8.6 percent in just over a year’s time. Going into the August FOMC meeting, my own forecast for unemployment was a little more optimistic, in the sense that I do expect unemployment to be under 8.5 percent by the end of next year. But, even with the more pessimistic SPF forecast, labor market slack is smaller than in November 2010, when the FOMC expected unemployment to remain around 9 percent in a year’s time.

So, measures of past and forecasts of future inflationary pressures were higher in August than at the time of the FOMC’s last major policy move in November. Measures of current labor market slack and expectations of future labor market slack were smaller in August. The monetary policy rules that I described earlier would suggest, again, “Don’t ease further if you’re doing better on your mandates.” Indeed, they’d recommend that the level of policy accommodation be reduced.

Instead, at its August meeting, the FOMC decided to adopt a more accommodative policy stance. From March 2009 through June 2011, the FOMC statement said that the Committee expected to keep interest rates extraordinarily low for an “extended period,” which was generally interpreted as meaning “at least for two or three meetings.” In August 2011, the FOMC changed its statement to say that it now expected to keep interest rates extraordinarily low for at least 16 meetings. Given what I’ve said, it is not surprising that I dissented from this decision.

I would be remiss if I did not mention one subtlety in my discussion of changes in the mandate dashboard since November 2010. I’ve treated the decline in the unemployment rate as representing a decline in labor market slack. This view is not uncontroversial. From an accounting perspective, the unemployment rate can fall for two reasons: People can find jobs, or people can stop searching for jobs. Much of the decline since November is attributable to people who were formerly unemployed choosing to no longer look for work.

Nonetheless, it still seems appropriate to me to view this change in labor market conditions as representing a decline in labor market slack. Intuitively, people who are non-employed, but not actively looking for work, are less likely to apply for any given job opening. Hence, the recent departures from the labor force imply that there is less downward pressure on wages. Almost by definition, from an economic perspective, this means that there is less slack in the labor market.

The rise in core inflation in the first part of the year is consistent with the view that labor market slack has fallen. But some observers argue that core PCE inflation is only temporarily high because of the tragic events in Japan or transitory spikes in commodity prices. If so, the disinflationary pressures of 2010 should soon reappear in the form of a sharp decline in current and expected core PCE inflation rates. In that eventuality, increasing policy accommodation might well be appropriate.

I’ve argued here that the Committee increased the level of accommodation when standard rules seem to call for standing pat or even reducing accommodation. What are the costs of such a move? The standard rules are meant to guide the economy toward the Committee’s medium-term objectives. If monetary policy is consistently overly accommodative relative to these rules, the Committee risks generating inflation higher than 2 percent for several years. As I’ve discussed, such an outcome could have significant consequences for inflation and inflation expectations. Future Committees might have to endure large losses in employment in order to fix these consequences.

Conclusion

I mentioned that I dissented from the Committee’s last decision in August. Two other presidents dissented—and there have not been as many dissents at one meeting in nearly 20 years. In my view, this level of disagreement reflects two aspects of the current setting. The first is related to the leadership of the Committee. Chairman Bernanke strongly welcomes the airing of disparate views within the meeting. He clearly believes—as I do—that the United States has a decentralized central bank because we will get better monetary policy if decision-making is grounded in a wide range of views. I think that the chairman should be applauded for this approach to policymaking.

The second is related to the nature of the economic data that we’ve seen in the first part of this year. I’ve described how inflation rose and unemployment fell. It’s also true that real GDP grew at less than 1 percent at an annualized rate in the first half of the year. And the outlook for real GDP growth has slipped too. Last November, my forecast for annual real GDP growth was similar to that of other FOMC participants: I expected that real GDP growth would average above 3 percent per year, and probably closer to 3.5 percent per year, over the following two years (that is, from the fourth quarter of 2010 through the fourth quarter of 2012). Now, I expect that real GDP growth will average around 2.5 percent per year over that same period of time.

It’s unusual to see an increase in inflation and a fall in unemployment occur when GDP growth is so sluggish and when the outlook for real GDP growth has slipped so much. It is hardly surprising that there might well be some disagreement about the appropriate monetary policy response to this conflicting mix of information.

As we go forward together on the Committee, I see no reason to revisit the decisions of August 2011. The Committee has included what I regard as a two-year conditional commitment in its statement. I believe that undoing this commitment in the near term would undercut the ability of the Committee to offer similar conditional commitments in the future—and this ability has certainly proved very useful in the past three years. So, I plan to abide by the August 2011 commitment in thinking about my own future decisions. Of course, the case for any additional easing would have to be made on its own merits. And, like the 19th century settlers of the American West, the Committee will have to keep its eye on the future when deciding about the present.

Thanks for your attention. I’m happy to take your questions.

Endnotes

References

Blanchard, Olivier J., and Jordi Galí. 2007. “Real Wage Rigidities and the New Keynesian Model.” Journal of Money, Credit and Banking Supplement 39, pp. 35-65.

Kocherlakota, Narayana. 2011. “Labor Markets and Monetary Policy.” 2010 Annual Report. Federal Reserve Bank of Minneapolis.

Justiniano, Alejandro, Giorgio E. Primiceri and Andrea Tambalotti. 2011. “Is There a Trade-Off Between Inflation and Output Stabilization?”

Meyer, Brent H., and Mehmet Pasaogullari. 2010. “Simple Ways to Forecast Inflation: What Works Best?”

Robinson, Elwyn B. 1966. History of North Dakota. University of Nebraska Press, p. 552.

.

Thank you very much for that kind introduction. I’ve been president of the Minneapolis Fed for nearly two years now. I’m often asked what I enjoy about my job. There are many possible answers, but one is certainly that it offers me a chance to visit Montana more than I would otherwise. This is definitely one of the most beautiful states in the Union.

I’m also delighted to have this opportunity to talk to this group in particular. You are all very aware that our country has gone through a difficult financial crisis and that we are still only beginning to make our way back from its impact. There have been many changes in financial regulation designed to reduce the risk of a recurrence of such a traumatic event. My goal today is to describe changes in the U.S. tax code that I believe will make such a crisis less likely to occur. And before going further, let me note that these remarks reflect my views, not necessarily those of others in the Federal Reserve System or on the Federal Open Market Committee.

My starting point is the Dodd-Frank Act. It’s less than a year old, having been passed in July of 2010. But, even in that short time, it already seems clear that it is the single most important piece of legislation related to the U.S. financial system to be passed in at least 75 years—and arguably ever. Its first nine words describe the purpose of the 848 pages that follow as being “to promote the financial stability of the United States.” The Act envisions the Federal Reserve System as being integral to the fulfillment of this mission. In particular, the Fed is designated the supervisor and regulator of all systemically important financial institutions—including those that are not banks.

The Dodd-Frank Act makes significant headway toward the goal of promoting U.S. financial stability, but as the Act itself indicates, there is more to be done.² And given the Federal Reserve System’s part in this mission, I believe it is incumbent on Fed leaders to point out ways in which Congress could potentially act to make the financial system even more stable. It is with this in mind that I’d like to offer the following contributions.

Of course, many Fed leaders have made these kinds of suggestions in the past, and I’m sure that they will do so in the future. In Minneapolis, my predecessor, Gary Stern, and my current head of supervision, Ron Feldman, did their part by writing a book in 2004 called Too Big to Fail. The book identified a host of incentives within the U.S. financial system that encouraged large banks to take on risks that could prove destabilizing. Their book has proven to be distressingly prescient. I will follow in Stern and Feldman’s footsteps by focusing on ways in which our current tax system provides incentives for financial institutions to make destabilizing choices.

My focus today is on the use of debt as a form of financing—that is to say—on leverage. I will be making three points.

• First, the sharp and largely unanticipated fall in U.S. residential land prices after 2006 was the main cause of the financial crisis of 2007-09.
• Second, household and financial institution leverage exacerbate the sensitivity of the financial system to declines in land prices and so reduce financial stability.
• Third, the U.S. tax system promotes leverage on the part of households and financial institutions.

My conclusion is that Congress should modify the U.S. tax system to reduce the incentives for destabilizing activities by banks and households.

As I have already indicated, my arguments will hinge throughout on what economists call incentive effects. One of my big surprises since taking this job is that there is a lot more skepticism among policymakers about the relevance of incentive effects than I would have thought. Basically, my point today about tax incentives is that if the tax system reduces the cost of one activity versus another, then people will do more of the first. I can restate this idea even more prosaically by saying that if apples fall in price relative to bananas, people will buy more apples, and fewer bananas, than previously. This proposition about choices is entirely obvious if one is willing to assume—as I generally do—that people behave in a purposive, goal-oriented way.

But this assumption of purposive behavior is sometimes controversial. For that reason, it’s worth emphasizing that the power of incentives does not rely on this assumption. By way of illustration, suppose that, in my apples and bananas example, people simply divide their available money randomly between apples and bananas. Gary Becker, a Nobel laureate at the University of Chicago, showed that, even with this seemingly irrational behavior, incentives still work their magic.³ Here’s why: Say you have $10. Now split that $10 into an amount you want to spend on apples and an amount you want to spend on bananas. However you choose to split the $10, it will end up buying more apples and fewer bananas if the apple price falls relative to the banana price. Becker’s point is that incentives are shaped by scarcity—here, the scarcity of money to spend on apples and bananas—not rationality. His message underscores the enormous power of incentive effects—and why they need to be considered in any policy discussion.

Let me now move on to talk about the behavior of land prices over the past 40 years. Right from the start, I’ll emphasize that I’m talking about land prices, not housing prices. A house is actually a bundle of two goods: a structure and the land underneath that structure. The price of the structure itself is largely dictated by the cost of materials and the cost of labor needed to build it. The prices of residential structures rose relatively little over the decade 1996-2006 and have fallen relatively little since 2006. Hence, the evolution of the price of housing over the past 15 years is really driven by movements in the price of residential land.

The data that I’ll use are maintained by the Lincoln Institute of Land Policy, together with the University of Wisconsin School of Business. They are constructed following a methodology originally due to Morris Davis of the University of Wisconsin and Jonathan Heathcote, a researcher at the Minneapolis Fed.⁴ These data reveal that U.S. residential land prices grew at 2 percent per year from the fourth quarter of 1975 to the first quarter of 1996 in real terms (that is, corrected for inflation). At that point, the rate of growth accelerated sharply. Real land prices grew at 11 percent per year from the first quarter of 1996 to the first quarter of 2001. Monetary policy is often blamed for what’s now termed a nationwide bubble in housing prices, so it’s worth noting that this original acceleration in prices took place during a period of relatively tight monetary policy. It also began before the passage of the Gramm-Leach-Bliley Act, which officially repealed the Glass-Steagall Act’s separation of commercial and investment banking.⁵ Prices did accelerate still further in the early 2000s, growing in real terms at a rate of 17 percent per year from 2001 to 2006.

By early 2006, the price of U.S. residential land had risen over 250 percent in a decade. Firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. land—mortgage-backed securities, for example, or any asset backed by them—and these investors viewed the assets as being largely free of risk. They may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip as they had over the past decade.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were starting to learn the hard way that U.S. land was a risky investment. Now the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.

What do I mean by the term financial panic? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits. In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much additional risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors and their creditors and so on. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly. The financial crisis of 2007-09 was under way.

Thus far, I’ve described how the fall in land prices that began in 2006 triggered the recent global financial crisis. I now move to my second point: Higher amounts of household and financial institution leverage mean that the financial system is more susceptible to these kinds of shocks.

To understand my argument, it is best to consider an example. Suppose a household buys a house worth $200,000. The household puts down $20,000 and borrows $180,000 from a bank through a nonrecourse mortgage—meaning that in the event of default, the bank has access only to the collateral: the house itself. The bank is a big one—it has $2 trillion worth of assets, $1 trillion of those assets consisting of mortgages (either through direct ownership or through ownership of mortgage-backed securities). The bank has $200 billion worth of outstanding equity—so its debt-to-equity ratio is 9-to-1. Here, I should be clear that my value references are all market-determined values.

Now, suppose that land prices fall, and so houses around the United States fall suddenly and permanently in value by 30 percent. For the house in my example, that means its value has fallen from $200,000 down to $140,000. The household is now significantly underwater because it owes $180,000 on a house worth $140,000. If the household loses its sources of income—as might well be true if houses around the country are worth 30 percent less—then it will have no choice but to default on the loan (through a short sale or a foreclosure). Even if the household keeps its sources of income, it’s now in a position where so-called strategic default on a nonrecourse mortgage is financially rewarding. The bottom line is that this mortgage once worth $180,000 is now worth much less, perhaps no more than $140,000. In other words, the 30 percent fall in the value of the underlying asset has led to as much as a 22 percent fall in the value of the mortgage itself.

This has severe implications for the bank, of course. Recall that $1 trillion of the bank’s assets took the form of these kinds of mortgages. Given the possible 22 percent drop on its mortgage values, the bank’s assets have fallen by as much as $220 billion, depending on the default choices of households. Its equity, originally worth $200 billion, will fall greatly in value—possibly to zero. It is a reasonable conjecture that it will not be able to raise new funds in debt or equity markets.

These troubles for a $2 trillion institution will almost automatically pose a systemic risk to the U.S. financial system. But I don’t view size as essential to my story. I could have told exactly the same story if I had described 200 banks that each had $10 billion in assets and $5 billion of these kinds of mortgages.

While size isn’t critical, there are three key variables that do matter in this little story. The first is household leverage. Remember that the house fell in value by $60,000. Suppose that the household had made a more traditional down payment of 20 percent rather than the 10 percent figure I used initially. The fall in home value would still leave the household underwater, but the mortgage value would have fallen by only $20,000, not $40,000. The bank’s assets would have fallen by at most $120 billion. It would not have risked insolvency.

The second relevant variable is bank asset concentration. In my example, the bank had half of its assets directly tied to U.S. residential land. If it had had only 30 percent of its assets in mortgages, then its losses could not have led to insolvency.

Finally—and perhaps most obviously—bank leverage matters. The bank in my example had a 9-to-1 debt-to-equity ratio. Had its debt-to-equity ratio been 4-to-1 instead, its equity of $400 billion would have outweighed its losses of $220 billion, and it would not have become insolvent.

Thus, household leverage and financial institution leverage render the financial sector more sensitive to downward movements in the price of land. This kind of sensitivity decreases the stability of the financial system and so increases the potential for the kind of crisis we endured in 2007-09.

On to my final point: The U.S. tax system encourages household leverage and bank leverage, even though both are potentially destabilizing. Let’s start with household leverage. Think about a family that wants to buy a $300,000 house. It has sufficient financial assets in stocks and bonds to cover half of the cost. Will it use these assets to fund half of the house price and take out a mortgage of $150,000? Or will it take a more levered position: Make a $60,000 down payment, and borrow the remaining $240,000?

It’s not possible to answer this question with certainty for any given household. But we know that the tax system provides an extra incentive for any given household to take out the larger loan. Under the current tax code, the household can deduct from its gross income any interest payments it makes on the extra $90,000 of mortgage debt. This means that the household’s after-tax interest rate on its mortgage is lower than it would otherwise be, making mortgage financing more attractive. It is in this sense that the mortgage interest tax deduction undercuts financial stability

In making this argument, I should note that only about one-third of U.S. tax returns itemize deductions and are therefore affected by the tax code’s leverage inducement. However, over 60 percent of those households that make over $50,000 do itemize, as do over three-quarters of those households that make over $75,000.⁶ And—contrary to some misconceptions—the mortgages of these relatively upper-income households are certainly relevant as we think about the impact of the fall in land prices. According to a recent online survey, just over 20 percent of mortgage-holding adults with incomes over $50,000—and a similar fraction of those with incomes over $75,000—believe that they are “underwater” on those mortgages.⁷ This fraction is pretty much the same as the percentage for all households.⁸

Next, I turn to financial institution leverage. Consider a financial institution that needs to raise an extra million dollars. It can do so by issuing debt or attracting deposits that pay 1 percent interest. Under this approach, the borrower owes $10,000 of interest to its creditors next year. Alternatively, it can raise the million dollars by issuing the same amount of equity. Abstracting from risk considerations, the equity holders will expect to be compensated by receiving $10,000 of dividend payments every year.

Which method of finance—debt or equity—will the financial institution choose? Taxes play a role in this decision. If it chooses the debt route, the bank can deduct its interest payments from its earnings before paying any corporate income taxes. If it chooses the equity route, then the financial institution must make its dividend payments from profits that are left after it pays corporate income taxes. Debt repayments are cheaper. In this way, the tax code includes what is known as a corporate debt tax shield that encourages higher leverage for financial institutions.

Through the previous discussion, I hope that I have convinced you of three main points. First, the financial system meltdown of 2007-09 was caused by the unexpectedly large decline in U.S. residential land prices. Second, higher amounts of household and financial institution leverage leave the financial system more vulnerable to these kinds of shocks. Finally, the U.S. tax system encourages leverage by providing incentives for households to take on more mortgage debt and financial institutions to finance through debt.

What policy conclusions should we draw from these points? As an economist, I have a full appreciation that every policy choice has both benefits and costs. Policymakers may well disagree about how to weigh those benefits and costs. However, I would say that the experience of the past few years has demonstrated how challenging it is to safeguard the financial system against systemic risk and how costly it can be if we fail to do so. Given this fresh experience, and my earlier remarks, I would assess the costs of providing tax incentives for leverage to be higher today than such an assessment in, say, 2006.

With that in mind, I believe that my analysis suggests two changes in the tax code. The first change is to lower the fraction of mortgage interest that households can deduct from their taxable incomes. The second is to lower the fraction of their interest payments that corporations⁹ are allowed to deduct from their taxable incomes. Of course, it would be appropriate and important to adjust the timing of these changes in light of prevailing macroeconomic conditions.

I regard these two proposals for the tax code as being entirely natural ones to consider in light of the recent financial crisis. But I would also encourage policymakers in the tax arena to ask broader questions about the mortgage interest and corporate interest tax deductions. What are the social benefits associated with these deductions? Can these social benefits be achieved using an approach that does not undercut the stability of the financial system? For example, suppose that a policymaker likes the mortgage interest deduction because he or she believes that it encourages home ownership. That policymaker could consider replacing the mortgage interest deduction with a tax credit that offsets part of a buyer’s down payment toward a home purchase. Such a tax credit would encourage home ownership without simultaneously providing more incentives for households to accumulate more debt.

Similarly, a policymaker may like the corporate interest tax deduction because it stimulates business investment. That policymaker could consider replacing the corporate interest tax deduction with a lower corporate income tax rate. The lower corporate income tax rate would encourage business investment without simultaneously providing incentives for corporations to acquire leverage.

Let me wrap up. In a speech last October, Janet Yellen, the vice chair of the Board of Governors of the Federal Reserve System, gave a speech about the roots of the recent financial crisis.¹⁰ As I have done today, she emphasized the critical role played by excessive household and financial institution leverage in generating the crisis. She described how the changes in supervision and regulation contained within the Dodd-Frank Act would put new and important brakes on these kinds of build-ups.

I agree with her completely about these benefits of the new supervisory and regulatory regime. But I also agree with her statement that “systemic risk surveillance will demand Herculean efforts by the regulatory agencies.” In my view, this observation means that other elements of the policy environment need to be as supportive as possible of the regulatory agencies. It is for this reason that I believe that policymakers should be willing to reconsider the extent of leverage subsidies within the U.S. tax code.

That brings me to the end of my prepared remarks. I would be happy to take your questions on what I have said, or on other any matters. Thanks for listening.

Endnotes

References

Becker, Gary S. 1962. "Irrational Behavior and Economic Theory." Journal of Politcal Economy 70 (1): 1-13.

CoreLogic Inc. 2011. “New CoreLogic Data Shows Slight Decrease in Negative Equity.” News Release, June 7.

Davis, Morris A., and Jonathan Heathcote. 2007. “The Price and Quantity of Residential Land in the United States.” Journal of Monetary Economics 54 (8): 2595-2620.

Harris Interactive Poll. 2011.

Internal Revenue Service. 2010. Statistics of Income Division. Individual Complete Report (Publication 1304), Table 1.2.

Shiller, Robert J. 2011. “The Sickness Beneath the Slump.” New York Times, June 11.

Yellen, Janet L. 2010. “Macroprudential Supervision and Monetary Policy in the Post-crisis World.”  Speech at the Annual Meeting of the National Association for Business Economics. Denver, Colo., Oct. 11.

Last July, Congress passed the Dodd-Frank Act. The Act’s goal is “to promote the financial stability of the United States,” and it envisions the Federal Reserve System as being integral to the fulfillment of this mission. With that in mind, I offer two observations.

The first is that household leverage and financial institution leverage both reduce financial stability. Intuitively, when households take on larger mortgages, financial institutions that own those mortgages suffer greater losses from any fall in the value of the underlying home. Similarly, financial institutions are less able to survive this fall in their asset values if they are highly leveraged. Thus, leverage exacerbates the sensitivity of the financial system to declines in land prices.

Secondly, the U.S. tax code provides explicit incentives for leverage. It encourages households to take on mortgage debt by allowing them to deduct mortgage interest payments from their taxable incomes. The code also encourages corporations to finance through debt by allowing them to deduct interest payments from their taxable incomes. In this way, our tax system provides incentives for activities that undercut financial stability.

All tax provisions have both costs and benefits. But the recent financial crisis taught us that such crises are associated with enormous macroeconomic costs. My main conclusion is that the costs of providing tax incentives for leverage are bigger than was generally perceived prior to the crisis.  

What does this conclusion imply for tax policy? I suggest that policymakers should consider two changes to the US tax code. The first is to reduce the fraction of mortgage interest payments that households are allowed to deduct from their taxable incomes. The second is to reduce the fraction of interest payments that corporations are allowed to deduct from their taxable incomes. Of course, policymakers should adjust the timing of these changes in light of prevailing macroeconomic conditions.

Re-thinking Leverage Subsidies - Full Speech

Thank you very much for that generous introduction. It is a pleasure to be able to spend time in Rochester, and I would like to thank the Rochester Area Chamber of Commerce for arranging this speech and other aspects of my visit. I see my visit to Rochester as a great example of the kind of two-way communication that I believe lies at the very heart of our Federal Reserve System. You’ll be hearing from me over the next 30 minutes or so. That kind of communication—from policymaker to public—is essential for good policymaking. Over the past 25 years, monetary policymakers all over the world—including here in the United States—have become more transparent about their deliberations and their thinking. This is a very positive development, and speeches like the one that I’m about to give play a huge role in that process. But communication in the other direction—from public to policymaker—is also critical to good policymaking. Along those lines, I spent the morning listening and learning in meetings with business leaders, and I very much look forward to learning more from your questions following my talk.

As was mentioned in the introduction, I am the president of the Federal Reserve Bank of Minneapolis. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

The Federal Open Market Committee—the FOMC—meets every six to seven weeks (eight times per year) to set the path of monetary policy. All 12 presidents of the various regional Federal Reserve banks and the seven governors of the Federal Reserve Board participate in these meetings. (Right now, there are only five governors—two positions are unfilled.) However, the actual policy decisions are made by the Committee itself. It consists only of the governors, the president of the Federal Reserve Bank of New York, and a group of four other presidents, which changes annually. Currently, I’m a member of the Committee (along with the presidents of the Federal Reserve Banks of Chicago, Dallas, and Philadelphia).

At each FOMC meeting, there are two go-rounds, in which each president and every member of the Board speaks in turn. The first go-round concerns current economic conditions and the economic outlook. The presidents typically say something about economic conditions in their own district, as well as talk about national economic conditions. The governors speak about national economic conditions, although they often focus their remarks on particular slices of the overall economic picture.

In the second go-round, we each speak in turn about our views on the current monetary policy choices. However, those discussions often range well beyond the confines of the next seven weeks. There is no sensible way to talk about current policy choices without linking them in some fashion to future policy choices. Hence, meeting participants may sometimes describe (as briefly as they can!) how they expect (or would like) policy to evolve over the coming months or even years.

My remarks today will be structured along the lines of an FOMC meeting. I will first discuss my outlook for the U.S. economy. I will then move on to talk about the key issues that I see affecting the FOMC’s policy choices over the coming months and years.

Before going further, I should say that my views are my own and not necessarily those of others in the Federal Reserve System or of others in the FOMC. This disclaimer is a standard one—but let me provide a little more detail about what it will mean about the remainder of my speech. I’m a member of the FOMC this year, and so I vote to determine the course of monetary policy at each meeting. Given my position, I believe that it is valuable for the public to know what economists would term my monetary policy reaction function—that is, my views about how monetary policy should react to various economic scenarios. Of course, the FOMC is made up of 10 different individuals, with 10 highly related, but nonetheless distinct, policy reaction functions. The ultimate reaction function of the FOMC is a collective one, and may well differ from that of any given Committee member. My remarks are only about the nature of my reaction function, and not the collective one of the FOMC.

With that context in place, let me move to my outlook. I’ll focus on the three variables of most interest to us at the FOMC: real gross domestic product (GDP), unemployment, and inflation. My bottom line is that, from the point of view of the macroeconomy, 2011 will be a better year than 2010.

Recently, the Bureau of Economic Analysis released its advance estimate for real GDP in the first quarter of 2011. By this estimate, real GDP grew at a 1.8 percent annual rate during the quarter. This growth rate is a bit slower than what we’ve seen since the end of the Great Recession: In the seven quarters since June 2009, real GDP growth has averaged just below 3 percent. This rate of growth is slow compared with the recovery in real GDP that took place after the recession of 1981-82. However, it is similar to the recoveries that took place after the recessions of 1991 and 2001.

Despite this somewhat slow start, I do expect that real GDP growth will be slightly faster in 2011 than in 2010—something around 3 percent. Given the depth of the recession that we experienced, this rate of growth is disappointing. I do still see two headwinds in the U.S. economy. The first is that many households will continue to strive to rebuild their net worth positions in response to past—and possibly future—falls in residential land prices. As I have discussed elsewhere,² I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery.

The second headwind is related. Many smaller banks in the United States face ongoing issues with asset quality. For example, the FDIC problem bank list contains over 800 banks. Problem banks are less likely to take the risk of lending to small and/or young firms and other entrepreneurial activities. Instead, they are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers. Indeed, as the economy improves, I suspect that this headwind will become even more important. In 2010, our information at the Minneapolis Fed indicates that small businesses were reluctant to expand because of ongoing uncertainties about product demand. As a result, their demand for bank financing remained low. In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.

Let me turn now to the labor market, where I see conditions improving slowly. The unemployment rate has fallen from 9.8 percent in November to 9.0 percent in April. However, unemployment can fall in two ways: People can find jobs or people can stop looking for work. Along these lines, it is worth keeping in mind that the employment-to-population ratio—the fraction of those over 16 with a job—has improved only slightly since November. This key variable remains near the quarter-century lows established in the Great Recession.

I see the future course of unemployment as being shaped by two conflicting forces. On the one hand, the growing economy should generate more jobs and therefore lower unemployment. On the other hand, the growing economy will also lead more people without jobs to look for them. On net, I do expect the unemployment rate to normalize at close to 5 percent within the next five years. However, the immediate progress will be slow: I expect that the unemployment rate will still be above 8 percent and is likely to be still close to 8.5 percent by the end of the year.

Finally, I turn to inflation. The FOMC is mandated by the Federal Reserve Act to keep prices stable. This mandate is typically translated quantitatively into a 2 percent rate of inflation, or a bit under. Here, by inflation, I’m referring to headline inflation—that is, the rate of price increase of a bundle of all consumer goods and services, including those related to food and energy. The problem is that monetary policy operates with relatively long lags. Hence, out of necessity, I view the Committee’s price stability mandate as requiring it to follow policies that will guide the economy toward 2 percent headline inflation over the next three to four years.

I believe that the Fed can best achieve this medium-term objective for headline inflation by responding on an ongoing basis to movements in what’s called core inflation. Core inflation is a measure of inflation that strips out food and energy products. I like core inflation as a measure of medium-term inflationary pressures because demand and supply conditions in food and energy markets are volatile, and so their prices tend to have relatively large transitory fluctuations. Responding aggressively to these fluctuations would lead to bad monetary policy. For example, increases in energy prices pushed headline personal consumption expenditure (PCE) inflation, when measured over the preceding year, up to 4.5 percent in July 2008. With hindsight, we can see that it is good that the FOMC did not raise rates in response to what proved to be a temporary increase in headline inflation.

From the fourth quarter of 2009 to the fourth quarter of 2010, core PCE inflation was 0.8 percent—the lowest annual inflation rate in the 50-plus-year history of that series. Inflation was low—but disinflationary pressures were still strong as core PCE inflation trended downward over the course of 2010. Over the last six months of 2010, the annualized core PCE inflation rate fell to 0.4 percent. That is the second-lowest 6-month core PCE inflation rate ever recorded.

I don’t expect this kind of disinflationary pattern to continue in 2011. Core PCE inflation from the fourth quarter of 2010 to the first quarter of 2011 was 1.5 percent at an annualized rate. Similarly, I expect that core inflation will be 1.5 percent over the remainder of 2011.

To summarize: I expect real output to grow slightly more rapidly in 2011 than in 2010. Household deleveraging and bank asset quality issues will remain a drag on the recovery. Unemployment will fall—but more slowly than we would like. Finally, inflationary pressures are currently low. I expect core PCE inflation to grow slowly over the course of 2011, while remaining under 2 percent.

What sort of faith should you put in these forecasts? Well, my history of making forecasts is short so far, because I only took over as president in October 2009. However, in February 2010, I gave my first speech as bank president and offered forecasts about 2010 real GDP, unemployment, and inflation. My forecasts for unemployment and GDP ended up being pretty accurate. However, my forecasts for 2010 headline and core inflation were both about a percentage point too high.

I encourage you to keep this forecasting error in mind as I move on to what would be the second go-round in the FOMC: the discussion of policy considerations. I’ll first discuss where we are now and then talk about possible monetary policy changes over the coming year. Just as is true in many actual FOMC policy go-rounds, you will see that my discussion will necessarily spill into choices and decisions to be made over the next five years.

The Federal Reserve currently has two forms of accommodative monetary policy in place. The first is that the FOMC is targeting a low fed funds rate of between 0 and 25 basis points. This kind of accommodation—keeping short-term interest rates low—is an entirely conventional response to unduly low levels of core inflation and unduly high levels of unemployment. By keeping market interest rates low, the policy encourages companies to invest their resources into hiring and business expansions, and it also encourages households to engage in more spending.

The second kind of accommodation is less conventional. The Fed has bought about 2.1 trillion dollars of longer-term government securities, and the FOMC has committed itself to buying an additional 0.2 trillion dollars of these securities by the end of June. The thinking behind this form of accommodation is that the FOMC’s holdings of 2.3 trillion dollars of longer-term securities raises their prices and lowers longer-term yields. In so doing, more long-term investments—like building factories or hiring workers—become more attractive to businesses.

Together, the low fed funds interest rate and the holdings of long-term government securities provide a formidable amount of monetary policy accommodation. We can quantify their joint effect using results in a recent research paper by Federal Reserve staff.³ That paper estimates that if the Fed buys 200 billion dollars worth of long-term government securities, the Fed provides stimulus to the economy equivalent to that achieved by lowering the fed funds rate by 25 basis points. This translation implies that, at the end of 2010, the FOMC’s total amount of monetary accommodation was roughly equivalent to what it could achieve by maintaining a fed funds rate of negative 2.5 percentage points.

This level of accommodation was adopted in November 2010, when the FOMC committed itself to buying 600 billion dollars of longer-term Treasuries by June 2011. The decision was nearly unanimous. I was not a member of the Committee at that time, but I did support the decision. We had seen a rather sharp fall in core inflation over the course of 2010, compared with what we had seen in 2009 and compared with what I had expected earlier in 2010. I believed that it was appropriate to ease policy in response to this fall in inflation. For myself, I would have preferred to have been able to lower the fed funds rate—but that option was not available.

Notice that the FOMC could have chosen a greater degree of accommodation by buying more long-term Treasuries. It could have chosen a smaller degree of accommodation by buying fewer long-term Treasuries. My conclusion is that, in late 2010, this level of accommodation was neither too tight nor too loose, given prevailing economic conditions.⁴

But economic conditions change, and monetary policy must adjust to those changes. Here’s a metaphor that may be helpful. We can think about the level of monetary accommodation as being akin to a gas pedal on a car and the Fed’s dual mandate as being a target speed. Right now, the car is going too slowly, and so the Fed has its foot on the accelerator.

There is one tricky part with the metaphor: with a car, a driver can just keep his foot on the gas until he hits his target speed. Monetary policy operates with long and variable lags—it’s like driving a car in which the car’s rate of acceleration responds 10 to 20 seconds after the driver adjusts the gas pedal. A driver of such a car will have to ease up on the gas as he gets closer to his target speed—or he will end up going too fast. In the same way, the Fed needs to lower its level of accommodation as it gets closer to fulfilling its price and employment mandates. Of course, like driving, monetary policy is an exercise in scenario analysis. If the car starts going uphill and its speed falls, then the driver needs to put more pressure on the gas. Similarly, if the economy were to move further from the Fed’s dual mandates over the course of 2011, then the FOMC would need to put more pressure on the monetary gas pedal and increase the level of its accommodation.

When I engage in monetary policy scenario analysis, I find it useful to start—but not finish—with my baseline economic forecast that I described earlier. When the FOMC adopted its current level of accommodation in late 2010, year-over-year core PCE inflation was 0.8 percent. My baseline forecast is that, by the end of 2011, core PCE inflation will be 1.5 percent—that is, 70 basis points higher than in the prior year. The Fed would then be closer to its price stability mandate—and so should ease the pressure on the monetary gas pedal. My recommendation in this scenario would be to raise the target fed funds rate by 50 basis points.

How do I arrive at this figure, as opposed to a smaller or larger one? There are three elements to my calculation. First, the standard response to a 70-basis-point increase would be to raise the target interest rate by a larger amount—that is, by at least 70 basis points. For example, the widely known rules associated with John Taylor of Stanford University would recommend that the response should be to raise the target interest rate by 1.5 times the increase in core inflation—that is, by 105 basis points.

Monetary policy should also adjust in response to changes in labor market slack. These changes are typically hard to measure. However, like many other economists’ forecasts, my baseline forecast is that the unemployment rate will be at least one percentage point lower at the end of 2011, relative to November 2010. This kind of fall in the unemployment rate would generally be viewed as signaling a decline in slack, as would the increase that I expect to see in core inflation. This fall in labor market slack would argue in favor of raising the fed funds rate by even more than the 105 basis points that I mentioned earlier.

These two elements—the increase in core PCE inflation and decline in labor market slack—imply that the target fed funds rate should be raised by at least a percentage point. However, there is a third effect that partially offsets the first two effects. The level of accommodation provided by the Fed’s holdings of long-term securities depends on how long people expect those holdings to last. To take an extreme, if the Fed were expected to sell all of its securities in the next day, those holdings would no longer provide any noticeable downward pressure on long-term interest rates. Now, the Fed is certainly not going to sell its securities tomorrow! But, at the end of 2011, we are presumably one year closer to the eventual normalization of the Fed’s balance sheet than we were at the end of 2010. The staff research paper that I mentioned earlier estimates the consequent reduction in accommodation to be roughly equivalent to a 50-basis-point increase in the fed funds rate.

By putting these three elements together, I arrive at my conclusion: If PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points. Of course, a core inflation rate of 1.5 percent is still markedly below the Fed’s price stability objective of 2 percent. Accordingly, an increase of 50 basis points in the fed funds rate would still leave the Fed in a highly accommodative stance. First, the fed funds rate would be extremely low—between 50 and 75 basis points. As well, the Fed’s holdings of long-term assets would continue to provide significant accommodation. Using estimates from the staff research that I mentioned earlier, we can conclude that the total monetary policy package of the two forms of accommodation would be roughly equivalent to maintaining a fed funds target rate of negative 1.5 percentage points. Such a stance can only be described as being easy monetary policy—just not as easy as late 2010.

Thus, under my baseline forecast, it would be desirable for the FOMC to raise the fed funds target interest rate by a modest amount toward the end of 2011. Of course, the FOMC could also reduce accommodation by shrinking the Fed’s holdings of long-term government securities. Such a reduction could take place in one of two ways. First, the FOMC is currently investing any principal payments from its securities holdings into long-term Treasuries. The Committee could decide to stop all or part of these reinvestments. This would provide a very modest reduction in accommodation. Alternatively, the Committee could reduce accommodation by choosing to sell some long-term assets.

These two approaches of reducing accommodation operate on the Fed’s balance sheet. I’m open to these approaches to reducing accommodation. However, based on what I know now, I would prefer to reduce accommodation primarily by raising the fed funds target interest rate. I have more confidence in that instrument of policy, based on our many years of experience with it. I suspect that this confidence is shared by the public at large.

I do think that the Fed needs to shrink its large balance sheet. But I see that as a longer-term mission that can take place over the next five or six years or so. I believe that this mission should be guided by two key principles. First, the Fed should commit itself to a path of shrinkage of its asset holdings. Second, that path should be sufficiently gradual that it will interact little with the effectiveness of monetary policy. Along these same lines, the FOMC should offer as much certainty as possible about the rate of shrinkage.

I have been describing how monetary policy should react to one particular scenario, my baseline forecast. As I noted, my baseline forecast about inflation was wrong last year, and could well be again this year. As a policymaker, I need to be prepared for that possibility. In terms of inflation, there are two kinds of errors to contemplate. On the one hand, my forecast for core PCE inflation might well be too high. If core PCE inflation were to fall over the course of 2011 relative to 2010, then it would be desirable for the FOMC to ease further in response to that decline. I imagine that easing would take place through the purchase of more long-term government securities.

On the other hand, my forecast for core PCE inflation might be too low. For example, core PCE inflation might rise to 1.8 percent over the course of 2011. The FOMC should respond to evidence of such a large increase by raising the target fed funds rate even more aggressively than I have suggested. I would recommend raising the target fed funds interest rate shortly thereafter.

Let me wrap up. My goal today has been to lay out my outlook for the economy and give you a sketch of how I believe monetary policy should react to changes in economic conditions. Under my baseline forecast, I believe that it would be appropriate for the FOMC to raise the fed funds target interest rate by a modest amount at the end of 2011. However, that forecast—like all forecasts—is subject to error. I’ve also discussed how my policy choices should and would react to those errors—that is, I’ve discussed my policy reaction function.

I began this speech by broadly describing the makeup of the Federal Reserve System and its policymaking body, the Federal Open Market Committee, as well as my role on that Committee. I raise this point again at the end to underscore the independent—yet collaborative—nature of the FOMC. As I described, each member of the FOMC has his or her own policy reaction function, grounded in our distinct but related views. I believe it is our responsibility to describe those views to the public. In that respect, I hope you found this speech enlightening, and I am happy to take your questions to provide fuller explanation on these and other matters. Thank you once again.

Endnotes

References

Chung, Hess, Jean-Philippe Laforte, David Reifschneider, and John C. Williams. 2011. "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?" Working Paper 2011-01. Federal Reserve Bank of San Francisco.

Kocherlakota, Narayana R. 2011. "It's a Wonderful Fed," Speech at Wisconsin Bankers Association, Madison, Wis., Jan 11.

Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice." Carnegie-Rochester Conference Series on Public Policy 39, 195-214.

Taylor, John B. 1999. "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules. Chicago: University of Chicago Press, pp. 319-41.

Thank you very much for that generous introduction. It is a pleasure to be with you today. I think that you will find that my speech is a fitting one to be addressed to the Forecasters' Club. In the first part of my talk, I will present my own forecast and will even provide a recounting of my scant track record as a forecaster. In the second part of my talk, I will discuss contingent planning for monetary policy. A key part of such planning is one's forecast, as well as the recognition that one's forecast will evolve as data come in. Over the past 25 years, monetary policymakers all over the world—including here in the United States—have become more transparent about their deliberations and their thinking. This is a very positive development. Speeches like this one play a huge role in that process. So I thank you for your invitation to join you here today and for the opportunity to share my views.

As was mentioned in the introduction, I am the president of the Federal Reserve Bank of Minneapolis. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

The Federal Open Market Committee—the FOMC—meets every six to seven weeks (eight times per year) to set the path of monetary policy. All 12 presidents of the various regional Federal Reserve banks and the seven governors of the Federal Reserve Board participate in these meetings. (Right now, there are only five governors—two positions are unfilled.) However, the actual policy decisions are made by the Committee itself. It consists only of the governors, the president of the Federal Reserve Bank of New York, and a group of four other presidents, which changes annually. Currently, I'm a member of the Committee (along with the presidents of the Federal Reserve Banks of Chicago, Dallas, and Philadelphia).

At each FOMC meeting, there are two go-rounds, in which each president and every member of the Board speaks in turn. The first go-round concerns current economic conditions and the economic outlook. The presidents typically say something about economic conditions in their own district, as well as talk about national economic conditions. The governors speak about national economic conditions, although they often focus their remarks on particular slices of the overall economic picture.

In the second go-round, we each speak in turn about our views on the current monetary policy choices. However, those discussions often range well beyond the confines of the next seven weeks. There is no sensible way to talk about current policy choices without linking them in some fashion to future policy choices. Hence, meeting participants may sometimes describe (as briefly as they can!) how they expect (or would like) policy to evolve over the coming months or even years.

My remarks today will be structured along the lines of an FOMC meeting. I will first discuss my outlook for the U.S. economy. I will then move on to talk about the key issues that I see affecting the FOMC's policy choices over the coming months and years.

Before going further, I should say that my views are my own and not necessarily those of others in the Federal Reserve System or of others in the FOMC. This disclaimer is a standard one—but let me provide a little more detail about what it will mean about the remainder of my speech. I'm a member of the FOMC this year, and so I vote to determine the course of monetary policy at each meeting. Given my position, I believe that it is valuable for the public to know what economists would term my monetary policy reaction function—that is, my views about how monetary policy should react to various economic scenarios. Of course, the FOMC is made up of 10 different individuals, with 10 highly related, but nonetheless distinct, policy reaction functions. The ultimate reaction function of the FOMC is a collective one, and may well differ from that of any given Committee member. My remarks are only about the nature of my reaction function, and not the collective one of the FOMC.

With that context in place, let me move to my outlook. I'll focus on the three variables of most interest to us at the FOMC: real gross domestic product (GDP), unemployment, and inflation. My bottom line is that, from the point of view of the macroeconomy, 2011 will be a better year than 2010.

Recently, the Bureau of Economic Analysis released its advance estimate for real GDP in the first quarter of 2011. This estimate implies that real GDP grew at a 1.8 percent annual rate during the quarter. This growth rate is a bit slower than what we've seen since the end of the Great Recession: In the seven quarters since June 2009, real GDP growth has averaged just below 3 percent. This rate of growth is slow compared with the recovery in real GDP that took place after the recession of 1981-82. However, it is similar to the recoveries that took place after the recessions of 1991 and 2001.

Despite this somewhat slow start, I do expect that real GDP growth will be slightly faster in 2011 than in 2010—something between 3 percent and 3.5 percent. Given the depth of the recession that we experienced, this rate of growth is disappointing. I do still see two headwinds in the U.S. economy. The first is that many households will continue to strive to rebuild their net worth positions in response to past—and possibly future—falls in residential land prices. As I have discussed elsewhere,² I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery.

The second headwind is related. Many smaller banks in the United States face ongoing issues with asset quality. For example, the FDIC problem bank list contains over 800 banks. Problem banks are less likely to take the risk of lending to small and/or young firms and other entrepreneurial activities. Instead, they are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers. Indeed, as the economy improves, I suspect that this headwind will become even more important. In 2010, our information at the Minneapolis Fed indicates that small businesses were reluctant to expand because of ongoing uncertainties about product demand. As a result, their demand for bank financing remained low. In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.

Let me turn now to the labor market, where I see conditions improving slowly. The unemployment rate has fallen from 9.8 percent in November to 9.0 percent in April. However, unemployment can fall in two ways: People can find jobs or people can stop looking for work. Along these lines, it is worth keeping in mind that the employment-to-population ratio—the fraction of those over 16 with a job—has improved only slightly since November. This key variable remains near the quarter-century lows established in the Great Recession.

I see the future course of unemployment as being shaped by two conflicting forces. On the one hand, the growing economy should generate more jobs and therefore lower unemployment. On the other hand, the growing economy will also lead more people without jobs to look for them. On net, I do expect the unemployment rate to normalize at close to 5 percent within the next five years. However, the immediate progress will be slow: I expect that the unemployment rate will be between 8 percent and 8.5 percent by the end of the year.

Finally, I turn to inflation. The FOMC is mandated by the Federal Reserve Act to keep prices stable. This mandate is typically translated quantitatively into a 2 percent rate of inflation, or a bit under. Here, by inflation, I'm referring to headline inflation—that is, the rate of price increase of a bundle of all consumer goods and services, including those related to food and energy. The problem is that monetary policy operates with relatively long lags. Hence, out of necessity, I view the Committee's price stability mandate as requiring it to follow policies that will guide the economy toward 2 percent headline inflation over the next three to four years.

I believe that the Fed can best achieve this medium-term objective for headline inflation by responding on an ongoing basis to movements in what's called core inflation. Core inflation is a measure of inflation that strips out food and energy products. I like core inflation as a measure of medium-term inflationary pressures because demand and supply conditions in food and energy markets are volatile, and so their prices tend to have relatively large transitory fluctuations. Responding aggressively to these fluctuations would lead to bad monetary policy. For example, increases in energy prices pushed headline personal consumption expenditure (PCE) inflation, when measured over the preceding year, up to 4.5 percent in July 2008. With hindsight, we can see that it is good that the FOMC did not raise rates in response to what proved to be a temporary increase in headline inflation.

From the fourth quarter of 2009 to the fourth quarter of 2010, core PCE inflation was 0.8 percent—the lowest annual inflation rate in the 50-plus-year history of that series. Inflation was low—but disinflationary pressures were still strong as core PCE inflation trended downward over the course of 2010. Over the last six months of 2010, the annualized core PCE inflation rate fell to 0.4 percent. That is the second-lowest 6-month core PCE inflation rate ever recorded.

I don't expect this kind of disinflationary pattern to continue in 2011. Core PCE inflation from the fourth quarter of 2010 to the first quarter of 2011 was 1.5 percent at an annualized rate. Similarly, I expect that core inflation will be 1.5 percent over the remainder of 2011.

To summarize: I expect real output to grow slightly more rapidly in 2011 than in 2010. Household deleveraging and bank asset quality issues will remain a drag on the recovery. Unemployment will fall—but more slowly than we would like. Finally, inflationary pressures are currently low. I expect core PCE inflation to grow slowly over the course of 2011, while remaining under 2 percent.

What sort of faith should you put in these forecasts? Well, my history of making forecasts is short so far, because I only took over as president in October 2009. However, in February 2010, I gave my first speech as bank president and offered forecasts about 2010 real GDP, unemployment, and inflation. My forecasts for unemployment and GDP ended up being pretty accurate. However, my forecasts for 2010 headline and core inflation were both about a percentage point too high.

I encourage you to keep this forecasting error in mind as I move on to what would be the second go-round in the FOMC: the discussion of policy considerations. I'll first discuss where we are now and then talk about possible monetary policy changes over the coming year. Just as is true in many actual FOMC policy go-rounds, you will see that my discussion will necessarily spill into choices and decisions to be made over the next five years.

The Federal Reserve currently has two forms of accommodative monetary policy in place. The first is that the FOMC is targeting a low fed funds rate of between 0 and 25 basis points. This kind of accommodation—keeping short-term interest rates low—is an entirely conventional response to unduly low levels of core inflation and unduly high levels of unemployment. By keeping market interest rates low, the policy encourages companies to invest their resources into hiring and business expansions, and it also encourages households to engage in more spending.

The second kind of accommodation is less conventional. The Fed has bought about 2.1 trillion dollars of longer-term government securities, and the FOMC has committed itself to buying an additional 0.2 trillion dollars of these securities by the end of June. The thinking behind this form of accommodation is that the FOMC's holdings of 2.3 trillion dollars of longer-term securities raises their prices and lowers longer-term yields. In so doing, more long-term investments—like building factories or hiring workers—become more attractive to businesses.

Together, the low fed funds interest rate and the holdings of long-term government securities provide a formidable amount of monetary policy accommodation. We can quantify their joint effect using results in a recent research paper by Federal Reserve staff.³ That paper estimates that if the Fed buys 200 billion dollars worth of long-term government securities, the Fed provides stimulus to the economy equivalent to that achieved by lowering the fed funds rate by 25 basis points. This translation implies that, at the end of 2010, the FOMC's total amount of monetary accommodation was roughly equivalent to what it could achieve by maintaining a fed funds rate of negative 2.5 percentage points.

This level of accommodation was adopted in November 2010, when the FOMC committed itself to buying 600 billion dollars of longer-term Treasuries by June 2011. The decision was nearly unanimous. I was not a member of the Committee at that time, but I did support the decision. We had seen a rather sharp fall in core inflation over the course of 2010, compared with what we had seen in 2009 and compared with what I had expected earlier in 2010. I believed that it was appropriate to ease policy in response to this fall in inflation. For myself, I would have preferred to have been able to lower the fed funds rate—but that option was not available.

Notice that the FOMC could have chosen a greater degree of accommodation by buying more long-term Treasuries. It could have chosen a smaller degree of accommodation by buying fewer long-term Treasuries. My conclusion is that, in late 2010, this level of accommodation was neither too tight nor too loose, given prevailing economic conditions.⁴

But economic conditions change, and monetary policy must adjust to those changes. Here's a metaphor that may be helpful. We can think about the level of monetary accommodation as being akin to a gas pedal on a car and the Fed's dual mandate as being a target speed. Right now, the car is going too slowly, and so the Fed has its foot on the accelerator.

There is one tricky part with the metaphor: with a car, a driver can just keep his foot on the gas until he hits his target speed. Monetary policy operates with long and variable lags—it's like driving a car in which the car's rate of acceleration responds 10 to 20 seconds after the driver adjusts the gas pedal. A driver of such a car will have to ease up on the gas as he gets closer to his target speed—or he will end up going too fast. In the same way, the Fed needs to lower its level of accommodation as it gets closer to fulfilling its price and employment mandates. Of course, like driving, monetary policy is an exercise in scenario analysis. If the car starts going uphill and its speed falls, then the driver needs to put more pressure on the gas. Similarly, if the economy were to move further from the Fed's dual mandates over the course of 2011, then the FOMC would need to put more pressure on the monetary gas pedal and increase the level of its accommodation.

When I engage in monetary policy scenario analysis, I find it useful to start—but not finish—with my baseline economic forecast that I described earlier. When the FOMC adopted its current level of accommodation in late 2010, year-over-year core PCE inflation was 0.8 percent. My baseline forecast is that, by the end of 2011, core PCE inflation will be 1.5 percent—that is, 70 basis points higher than in the prior year. The Fed would then be closer to its price stability mandate—and so should ease the pressure on the monetary gas pedal. My recommendation in this scenario would be to raise the target fed funds rate by 50 basis points.

How do I arrive at this figure, as opposed to a smaller or larger one? There are three elements to my calculation. First, the standard response to a 70 basis points increase would be to raise the target interest rate by a larger amount—that is, by at least 70 basis points. For example, the widely known rules associated with John Taylor of Stanford University would recommend that the response should be to raise the target interest rate by 1.5 times the increase in core inflation—that is, by 105 basis points.

Monetary policy should also adjust in response to changes in labor market slack. These changes are typically hard to measure. However, like many other economists' forecasts, my baseline forecast is that the unemployment rate will be at least one percentage point lower at the end of 2011, relative to November 2010. This kind of fall in the unemployment rate would generally be viewed as signaling a decline in slack, as would the increase that I expect to see in core inflation. This fall in labor market slack would argue in favor of raising the fed funds rate by even more than the 105 basis points that I mentioned earlier.

These two elements—the increase in core PCE inflation and decline in labor market slack—imply that the target fed funds rate should be raised by at least a percentage point. However, there is a third effect that partially offsets the first two effects. The level of accommodation provided by the Fed's holdings of long-term securities depends on how long people expect those holdings to last. To take an extreme, if the Fed were expected to sell all of its securities in the next day, those holdings would no longer provide any noticeable downward pressure on long-term interest rates. Now, the Fed is certainly not going to sell its securities tomorrow! But, at the end of 2011, we are presumably one year closer to the eventual normalization of the Fed's balance sheet than we were at the end of 2010. The staff research paper that I mentioned earlier estimates the consequent reduction in accommodation to be roughly equivalent to a 50-basis-point increase in the fed funds rate.

By putting these three elements together, I arrive at my conclusion: if PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points. Of course, a core inflation rate of 1.5 percent is still markedly below the Fed's price stability objective of 2 percent. Accordingly, an increase of 50 basis points in the fed funds rate would still leave the Fed in a highly accommodative stance. First, the fed funds rate would be extremely low—between 50 and 75 basis points. As well, the Fed's holdings of long-term assets would continue to provide significant accommodation. Using estimates from the staff research that I mentioned earlier, we can conclude that the total monetary policy package of the two forms of accommodation would be roughly equivalent to maintaining a fed funds target rate of negative 1.5 percentage points. Such a stance can only be described as being easy monetary policy—just not as easy as late 2010.

Thus, under my baseline forecast, it would be desirable for the FOMC to raise the fed funds target interest rate by a modest amount toward the end of 2011. Of course, the FOMC could also reduce accommodation by shrinking the Fed's holdings of long-term government securities. Such a reduction could take place in one of two ways. First, the FOMC is currently investing any principal payments from its securities holdings into long-term Treasuries. The Committee could decide to stop all or part of these reinvestments. Alternatively, the Committee could reduce accommodation by choosing to sell some long-term assets.

These two approaches of reducing accommodation operate on the Fed's balance sheet. I'm open to these approaches to reducing accommodation. However, based on what I know now, I would prefer to reduce accommodation by raising the fed funds target interest rate. I have more confidence in that instrument of policy, based on our many years of experience with it. I suspect that this confidence is shared by the public at large.

I do think that the Fed needs to shrink its large balance sheet. But I see that as a longer-term mission that can take place over the next five or six years or so. I believe that this mission should be guided by two key principles. First, the Fed should commit itself to a path of shrinkage of its asset holdings. Second, that path should be sufficiently gradual that it will interact little with the effectiveness of monetary policy. Along these same lines, the FOMC should offer as much certainty as possible about the rate of shrinkage.

I have been describing how monetary policy should react to one particular scenario, my baseline forecast. As I noted, my baseline forecast about inflation was wrong last year, and could well be again this year. As a policymaker, I need to be prepared for that possibility. In terms of inflation, there are two kinds of errors to contemplate. On the one hand, my forecast for core PCE inflation might well be too high. If core PCE inflation were to fall over the course of 2011 relative to 2010, then it would be desirable for the FOMC to ease further in response to that decline. I imagine that easing would take place through the purchase of more long-term government securities.

On the other hand, my forecast for core PCE inflation might be too low. For example, core PCE inflation might rise to 1.8 percent over the course of 2011. The FOMC should respond to evidence of such a large increase by raising the target fed funds rate even more aggressively than I have suggested. I would recommend raising the target fed funds interest rate shortly thereafter.

Let me wrap up. My goal today has been to lay out my outlook for the economy and give you a sketch of how I believe monetary policy should react to changes in economic conditions. Under my baseline forecast, I believe that it would be appropriate for the FOMC to raise the fed funds target interest rate by a modest amount at the end of 2011. However, that forecast—like all forecasts—is subject to error. I've also discussed how my policy choices should and would react to those errors—that is, I've discussed my policy reaction function.

I began this speech by broadly describing the makeup of the Federal Reserve System and its policymaking body, the Federal Open Market Committee, as well as my role on that Committee. I raise this point again at the end to underscore the independent—yet collaborative—nature of the FOMC. As I described, each member of the FOMC has his or her own policy reaction function, grounded in our distinct but related views. I believe it is our responsibility to describe those views to the public. In that respect, I hope you found this speech enlightening, and I am happy to take your questions to provide fuller explanation on these and other matters. Thank you once again.

Endnotes

References

Chung, Hess, Jean-Philippe Laforte, David Reifschneider, and John C. Williams. 2011. "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?" Working Paper 2011-01. Federal Reserve Bank of San Francisco.

Kocherlakota, Narayana R. 2011. "It's a Wonderful Fed," Speech at Wisconsin Bankers Association, Madison, Wis., Jan 11.

Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice." Carnegie-Rochester Conference Series on Public Policy 39, 195-214.

Taylor, John B. 1999. "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules. Chicago: University of Chicago Press, pp. 319-41.

Thank you very much for that generous introduction. I am delighted to have this opportunity to be part of this year's Santa Barbara County Economic Summit. Over the past 25 years, monetary policymakers all over the world—including here in the United States—have become more transparent about their deliberations and their thinking. Speeches like this one play a huge role in that process. So I thank you for your invitation to join you here today and for the opportunity to share my views.

As was mentioned in the introduction, I am the president of the Federal Reserve Bank of Minneapolis. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

The Federal Open Market Committee—the FOMC—meets every six to seven weeks (eight times per year) to set the path of monetary policy. All 12 presidents of the various regional Federal Reserve banks and the seven governors of the Federal Reserve Board participate in these meetings. (Right now, there are only five governors—two positions are unfilled.) However, the actual policy decisions are made by the Committee itself. It consists only of the governors, the president of the Federal Reserve Bank of New York, and a group of four other presidents, which changes annually. Currently, I'm a member of the Committee (along with the presidents of the Federal Reserve Banks of Chicago, Dallas, and Philadelphia).

At each FOMC meeting, there are two go-rounds, in which each president and every member of the Board speaks in turn. The first go-round concerns current economic conditions and the economic outlook. The presidents typically say something about economic conditions in their own district, as well as talk about national economic conditions. The governors speak about national economic conditions, although they often focus their remarks on particular slices of the overall economic picture.

In the second go-round, we each speak in turn about our views on the current monetary policy choices. However, those discussions often range well beyond the confines of the next seven weeks. There is no sensible way to talk about current policy choices without linking them in some fashion to future policy choices. Hence, meeting participants may sometimes describe (as briefly as they can!) how they expect (or would like) policy to evolve over the coming months or even years.

My remarks today will be structured along the lines of an FOMC meeting. I will first discuss my outlook for the U.S. economy. I will then move on to talk about the key issues that I see affecting the FOMC's policy choices over the coming months and years.

Before going further, I should say that my views are my own and not necessarily those of others in the Federal Reserve System or of others in the FOMC. This disclaimer is a standard one—but let me provide a little more detail about what it will mean about the remainder of my speech. I'm a member of the FOMC this year, and so I vote to determine the course of monetary policy at each meeting. Given my position, I believe that it is valuable for the public to know what economists would term my monetary policy reaction function—that is, my views about how monetary policy should react to various economic scenarios. Of course, the FOMC is made up of 10 different individuals, with 10 highly related, but nonetheless distinct, policy reaction functions. The ultimate reaction function of the FOMC is a collective one, and may well differ from that of any given Committee member. My remarks are only about the nature of my reaction function, and not the collective one of the FOMC.

With that context in place, let me move to my outlook. I'll focus on the three variables of most interest to us at the FOMC: real—that is, inflation-adjusted—gross domestic product (GDP), unemployment, and inflation. My bottom line is that, from the point of view of the macroeconomy, 2011 will be a better year than 2010.

Recently, the Bureau of Economic Analysis released its advance estimate for real GDP in the first quarter of 2011. This estimate implies that real GDP grew at a 1.8 percent annual rate during the quarter. This growth rate is a bit slower than what we've seen since the end of the Great Recession: In the seven quarters since June 2009, real GDP growth has averaged just below 3 percent. This rate of growth is slow compared with the recovery in real GDP that took place after the recession of 1981-82. However, it is similar to the recoveries that took place after the recessions of 1991 and 2001.

Despite this somewhat slow start, I do expect that real GDP growth will be slightly faster in 2011 than in 2010—something between 3 percent and 3.5 percent. Given the depth of the recession that we experienced, this rate of growth is disappointing. I do still see two headwinds in the U.S. economy. The first is that many households will continue to strive to rebuild their net worth positions in response to past—and possibly future—falls in residential land prices. As I have discussed elsewhere,² I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery.

The second headwind is related. Many smaller banks in the United States face ongoing issues with asset quality. For example, the FDIC problem bank list contains over 800 banks. Problem banks are less likely to take the risk of lending to small and/or young firms and other entrepreneurial activities. Instead, they are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers. Indeed, as the economy improves, I suspect that this headwind will become even more important. In 2010, our information at the Minneapolis Fed indicates that small businesses were reluctant to expand because of ongoing uncertainties about product demand. As a result, their demand for bank financing remained low. In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.

Let me turn now to the labor market, where I see conditions improving slowly. The unemployment rate has fallen from 9.8 percent in November to 8.8 percent in March. However, unemployment can fall in two ways: People can find jobs or people can stop looking for work. Along these lines, it is worth keeping in mind that the employment-to-population ratio—the fraction of those over 16 with a job—has improved only slightly since November and remains near quarter-century lows.

I see the future course of unemployment as being shaped by two conflicting forces. On the one hand, the growing economy should generate more jobs and therefore lower unemployment. On the other hand, the growing economy will also lead more people without jobs to look for them. On net, I do expect the unemployment rate to normalize at close to 5 percent within the next five years. However, the immediate progress will be slow: I expect that the unemployment rate will be between 8 percent and 8.5 percent by the end of the year.

Finally, I turn to inflation. The FOMC is mandated by the Federal Reserve Act to keep prices stable. This mandate is typically translated quantitatively into a 2 percent rate of inflation, or a bit under. Here, by inflation, I'm referring to headline inflation—that is, the rate of price increase of a bundle of all consumer goods and services, including those related to food and energy. The problem is that monetary policy operates with relatively long lags. Hence, out of necessity, I view the Committee's price stability mandate as requiring it to follow policies that will guide the economy toward 2 percent headline inflation over the next three to four years.

I believe that the Fed can best achieve this medium-term objective for headline inflation by responding on an ongoing basis to movements in what's called core inflation. Core inflation is a measure of inflation that strips out food and energy products. I like core inflation as a measure of medium-term inflationary pressures because demand and supply conditions in food and energy markets are volatile, and so their prices tend to have relatively large transitory fluctuations. Responding aggressively to these fluctuations would lead to bad monetary policy. For example, increases in energy prices pushed headline personal consumption expenditure (PCE) inflation, when measured over the preceding year, up to 4.5 percent in July 2008. With hindsight, we can see that it is good that the FOMC did not raise rates in response to what proved to be a temporary increase in headline inflation.

From the fourth quarter of 2009 to the fourth quarter of 2010, core PCE inflation was 0.8 percent—the lowest annual inflation rate in the 50-plus-year history of that series. Inflation was low—but disinflationary pressures were still strong as core PCE inflation trended downward over the course of 2010. Over the last six months of 2010, the annualized core PCE inflation rate fell to 0.4 percent. That is the second-lowest 6-month core PCE inflation rate ever recorded.

I don't expect this kind of disinflationary pattern to continue in 2011. Core PCE inflation from the fourth quarter of 2010 to the first quarter of 2011 was 1.5 percent at an annualized rate. Similarly, I expect that core inflation will be 1.5 percent over the remainder of 2011.

To summarize: I expect real output to grow slightly more rapidly in 2011 than in 2010. Household deleveraging and bank asset quality issues will remain a drag on the recovery. Unemployment will fall—but more slowly than we would like. Finally, inflationary pressures are currently low. I expect core PCE inflation to grow slowly over the course of 2011, while remaining under 2 percent.

What sort of faith should you put in these forecasts? Well, my history of making forecasts is short so far, because I only took over as president in October 2009. However, in February 2010, I gave my first speech as bank president and offered forecasts about 2010 real GDP, unemployment, and inflation. My forecasts for unemployment and GDP ended up being pretty accurate. However, my forecasts for 2010 headline and core inflation were both about a percentage point too high.

I encourage you to keep this forecasting error in mind as I move on to what would be the second go-round in the FOMC: the discussion of policy considerations. I'll first discuss where we are now and then talk about possible monetary policy changes over the coming year. Just as is true in many actual FOMC policy go-rounds, you will see that my discussion will necessarily spill into choices and decisions to be made over the next five years.

The Federal Reserve currently has two forms of accommodative monetary policy in place. The first is that the FOMC is targeting a low fed funds rate of between 0 and 25 basis points. This kind of accommodation—keeping short-term interest rates low—is an entirely conventional response to unduly low levels of core inflation and unduly high levels of unemployment. By keeping market interest rates low, the policy encourages companies to invest their resources into hiring and business expansions, and it also encourages households to engage in more spending.

The second kind of accommodation is less conventional. The Fed has bought about 2.1 trillion dollars of longer-term government securities, and the FOMC has committed itself to buying an additional 0.2 trillion dollars of these securities by the end of June. The thinking behind this form of accommodation is that the FOMC's holdings of 2.3 trillion dollars of longer-term securities raises their prices and lowers longer-term yields. In so doing, more long-term investments—like building factories or hiring workers—become more attractive to businesses.

Together, the low fed funds interest rate and the holdings of long-term government securities provide a formidable amount of monetary policy accommodation. We can quantify their joint effect using results in a recent research paper by Federal Reserve staff.³ That paper estimates that if the Fed buys 200 billion dollars worth of long-term government securities, the Fed provides stimulus to the economy equivalent to that achieved by lowering the fed funds rate by 25 basis points. This translation implies that, at the end of 2010, the FOMC's total amount of monetary accommodation was roughly equivalent to what it could achieve by maintaining a fed funds rate of negative 2.5 percentage points.

This level of accommodation was adopted in November 2010, when the FOMC committed itself to buying 600 billion dollars of longer-term Treasuries by June 2011. The decision was nearly unanimous. I was not a member of the Committee at that time, but I did support the decision. We had seen a rather sharp fall in core inflation over the course of 2010, compared with what we had seen in 2009 and compared with what I had expected earlier in 2010. I believed that it was appropriate to ease policy in response to this fall in inflation. For myself, I would have preferred to have been able to lower the fed funds rate—but that option was not available.

Notice that the FOMC could have chosen a greater degree of accommodation by buying more long-term Treasuries. It could have chosen a smaller degree of accommodation by buying fewer long-term Treasuries. My conclusion is that, in late 2010, this level of accommodation was neither too tight nor too loose, given prevailing economic conditions.⁴

But economic conditions change, and monetary policy must adjust to those changes. Here's a metaphor that may be helpful. We can think about the level of monetary accommodation as being akin to a gas pedal on a car and the Fed's dual mandate as being a target speed. Right now, the car is going too slowly, and so the Fed has its foot on the accelerator.

There is one tricky part with the metaphor: with a car, a driver can just keep his foot on the gas until he hits his target speed. Monetary policy operates with long and variable lags—it's like driving a car in which the car's rate of acceleration responds 10 to 20 seconds after the driver adjusts the gas pedal. A driver of such a car will have to ease up on the gas as he gets closer to his target speed—or he will end up going too fast. In the same way, the Fed needs to lower its level of accommodation as it gets closer to fulfilling its price and employment mandates. Of course, like driving, monetary policy is an exercise in scenario analysis. If the car starts going uphill and its speed falls, then the driver needs to put more pressure on the gas. Similarly, if the economy were to move further from the Fed's dual mandates over the course of 2011, then the FOMC would need to put more pressure on the monetary gas pedal and increase the level of its accommodation.

When I engage in monetary policy scenario analysis, I find it useful to start—but not finish—with my baseline economic forecast that I described earlier. When the FOMC adopted its current level of accommodation in late 2010, year-over-year core PCE inflation was 0.8 percent. My baseline forecast is that, by the end of 2011, core PCE inflation will be 1.5 percent—that is, 70 basis points higher than in the prior year. The Fed would then be closer to its price stability mandate—and so should ease the pressure on the monetary gas pedal. The standard response to such an increase in core PCE inflation would be to raise the target interest rate by a larger amount—that is, by at least 70 basis points. For example, the widely known rules associated with John Taylor of Stanford University would recommend that the response should be to raise the target interest rate by 1.5 times the increase in core inflation—that is, by 105 basis points.

Monetary policy should also adjust in response to changes in labor market slack. These changes are typically hard to measure. However, like many other economists' forecasts, my baseline forecast is that the unemployment rate will be at least one percentage point lower at the end of 2011, relative to November 2010. This kind of fall in the unemployment rate would generally be viewed as signaling a decline in slack, as would the increase that I expect to see in core inflation. This fall in labor market slack would argue in favor of raising the fed funds rate by even more than the 105 basis points that I mentioned earlier.

So far, my analysis implies that my baseline forecast should trigger an increase in the target fed funds rate of at least 105 basis points. However, there is an offsetting effect that deserves mention. The level of accommodation provided by the Fed's long-term securities depends on how long people expect those holdings to last. To take an extreme, if the Fed were expected to sell all of its holdings in the next day, those holdings would obviously no longer provide any noticeable downward pressure on long-term interest rates. Now, the Fed is certainly not going to sell its holdings tomorrow! But, at the end of 2011, we are presumably one year closer to the eventual normalization of the Fed's balance sheet than we were at the end of 2010. The staff research paper that I mentioned earlier provides an estimate of the consequent reduction in accommodation as being roughly equivalent to a 50-basis-point increase in the fed funds rate.

Now, let's put all of this analysis together. It implies that if PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points. Of course, a core inflation rate of 1.5 percent is still markedly below the Fed's price stability objective of 2 percent. Accordingly, an increase of 50 basis points in the fed funds rate would still leave the Fed in a highly accommodative stance. First, the fed funds rate would be extremely low—between 50 and 75 basis points. As well, the Fed's holdings of long-term assets would continue to provide significant accommodation. Using estimates from the staff research that I mentioned earlier, we can conclude that the total monetary policy package of the two forms of accommodation would be roughly equivalent to maintaining a fed funds target rate of negative 1.5 percentage points. Such a stance can only be described as being easy monetary policy—just not as easy as late 2010.

Thus, under my baseline forecast, it would be desirable for the FOMC to raise the fed funds target interest rate by a modest amount toward the end of 2011. Of course, the FOMC could also reduce accommodation by shrinking the Fed's holdings of long-term government securities. Such a reduction could take place in one of two ways. First, the FOMC is currently investing any principal payments from its securities holdings into long-term Treasuries. The Committee could decide to stop all or part of these reinvestments.Alternatively, the Committee could reduce accommodation by choosing to sell some long-term assets.

These two approaches of reducing accommodation operate on the Fed's balance sheet. I'm open to these approaches to reducing accommodation. However, based on what I know now, I would prefer to reduce accommodation by raising the fed funds target interest rate. I have more confidence in that instrument of policy, based on our many years of experience with it. I suspect that this confidence is shared by the public at large.

I do think that the Fed needs to shrink its large balance sheet. But I see that as a longer-term mission that can take place over the next five or six years or so. I believe that this mission should be guided by two key principles. First, the Fed should commit itself to a viable path of shrinkage of its asset holdings. Second, that path should be sufficiently gradual that it will interact little with the effectiveness of monetary policy. Along these same lines, the FOMC should offer as much certainty as possible about the rate of shrinkage.

I have been describing how monetary policy should react to one particular scenario, my baseline forecast. As I noted, my baseline forecast about inflation was wrong last year, and could well be again this year. As a policymaker, I need to be prepared for that possibility. In terms of inflation, there are two kinds of errors to contemplate. On the one hand, my forecast for core PCE inflation might well be too high. If core PCE inflation were to fall over the course of 2011 relative to 2010, then it would be desirable for the FOMC to ease further in response to that decline. I imagine that easing would take place through the purchase of more long-term government securities.

On the other hand, my forecast for core PCE inflation might be too low. For example, core PCE inflation might rise to 1.8 percent over the course of 2011. But incoming data would reveal such a rapid increase to the FOMC early in the third quarter of 2011. I would recommend raising the target fed funds interest rate shortly thereafter.

Let me wrap up. My goal today has been to lay out my outlook for the economy and give you a sketch of how I believe monetary policy should react to changes in economic conditions. Under my baseline forecast, I believe that it would be appropriate for the FOMC to raise the fed funds target interest rate by a modest amount at the end of 2011. However, that forecast—like all forecasts—is subject to error. I've also discussed how my policy choices should and would react to those errors—that is, I've discussed my policy reaction function.

I began this speech by broadly describing the makeup of the Federal Reserve System and its policymaking body, the Federal Open Market Committee, as well as my role on that Committee. I raise this point again at the end to underscore the independent—yet collaborative—nature of the FOMC. As I described, each member of the FOMC has his or her own policy reaction function, grounded in our distinct but related views. I believe it is our responsibility to describe those views to the public. In that respect, I hope you found this speech enlightening, and I am happy to take your questions to provide fuller explanation on these and other matters. Thank you once again.

Endnotes

References

Chung, Hess, Jean-Philippe Laforte, David Reifschneider, and John C. Williams. 2011. "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?" Working Paper 2011-01. Federal Reserve Bank of San Francisco.

Kocherlakota, Narayana R. 2011. "It’s a Wonderful Fed," Speech at Wisconsin Bankers Association, Madison, Wis., Jan 11.

Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice." Carnegie-Rochester Conference Series on Public Policy 39, 195-214.

Taylor, John B. 1999. "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules. Chicago: University of Chicago Press, pp. 319-41.

Good morning. I am pleased to be here and have a chance to talk with you. My ability to engage in this kind of dialogue reflects the characteristically American design of the Federal Reserve System. Unlike most central banks, the Fed was designed to be a regional organization, so that residents of cities and rural areas from across the country can hear from central bank officials in person and directly add their voices to the monetary policy process. I and my senior management colleagues regularly hear from our boards of directors and advisory councils at both the Minneapolis Federal Reserve Bank and our Helena branch, and I really appreciate the opportunities I have to get out to Helena and other Ninth District cities and communities.

Often, at events like this, I provide comments on the economic outlook or monetary policy and then interact with the audience, to get their insights into the issues facing households, businesses, and local governments. I find those opportunities incredibly valuable, both to communicate what the Fed is doing and to hear how our policies, and economic forces generally, are affecting people like you.

Today, however, I want to forgo my usual monetary policy themes and talk about another way in which the Federal Reserve interacts with citizens at the local level to promote economic prosperity. I have in mind our Community Development program, which collaborates with partners across the Ninth District to enhance the foundations of an open and accessible market economy. More specifically, I want to talk about some important work our Community Development staff are engaged in, much of it here in Montana, to assist tribal leaders who are strengthening the institutions of business law that prevail on Indian reservations. First, however, I must note that the views I present are mine and not those of the Federal Reserve System or the Federal Open Market Committee.

Community Development

The Fed’s Community Development function is not the most prominent of our policy tools, but it provides a useful complement to our better-known tools, such as monetary policy and banking supervision. For example, one of our staff in Helena, Sue Woodrow, helped found the Montana Financial Education Coalition as part of her Community Development work to ensure that low- and moderate-income Montanans would know how to access credit markets prudently and effectively. But that same effort provides a broader benefit to the Fed, because monetary policy is also more effective if consumers and business owners understand concepts like inflation and compound interest. For another example, Sue and her colleagues gathered intelligence last year on the factors that were impeding the flow of credit from banks to small businesses, one of the sectors targeted by our Community Development program. But the results of that exercise were also shared with management in Minneapolis and ultimately with Chairman Bernanke at a national forum in Washington.

Our Community Development program has roots in the Community Reinvestment Act of 1977, which requires federal regulators to assess that financial institutions are meeting, safely and soundly, the credit needs of their entire community or market, including credit needs in low- or moderate-income neighborhoods. Out of that basic regulatory responsibility, the Federal Reserve gave the Community Development program the mission of supporting the Fed’s economic growth objectives by working beyond our walls and independently from our bank examiners to promote fair and impartial access to credit and financial services.

In pursuing this mission, the Minneapolis Community Development team often works with external partners to shore up the foundations of a well-functioning market economy, including initiatives on financial education like the one I mentioned. This year, they also will work to strengthen organizations that provide training and credit to small businesses, to assist foreclosure and housing counselors, and to support organizations that foster rural development and post-foreclosure neighborhood recovery. In a very local but important way, these efforts supplement the Fed’s other policy tools for promoting economic growth.

Work in Indian Country

As you might imagine, the range of issues our Community Development staff might try to address is vast. I should note, by the way, that we do not operate as a foundation and thus do not provide cash contributions or donations to any organization. Our community development work is primarily conducted through staff work on outreach, technical assistance, and analysis. To thoroughly cover the entire community development field would take significantly more staff than we have. So we have identified some high-priority areas where we think we can make a difference by focusing our efforts. One of our highest Community Development priorities is the one I want to focus on this morning—supporting tribes as they strengthen the legal foundations of their Indian Country economies. By the way, I am using the term Indian Country as a consistent term to describe the many self-governing Native American communities throughout the United States.

A New Voyage of Discovery

I find these efforts to strengthen legal foundations of Indian Country economies to be very interesting and full of potential, but thinking about them here also reminds me of their historical roots. A bit over 200 years ago, Lewis and Clark and their Corps of Discovery passed near here on a federally sponsored voyage that launched a powerful transformation of Montana and the American West. That transformation led to tremendous economic development, but, as we know, also relegated most of the region’s tribal societies to reservations. For decades thereafter, the tribes’ affairs were largely administered by federal officials who permitted them very little local autonomy. Partly as a result, economic development lagged on most reservations, leaving them as pockets of sharp rural poverty.

Federal policy began to shift in the 1930s, with passage of the Indian Reorganization Act, which led to the drafting of numerous tribal government constitutions. But federal policy wavered for another 40 years, including a significant shift away from tribal recognition and sovereign rights in the 1950s. By the 1970s, however, civil rights activism and a shift toward market-oriented economic policies created a consensus in support of greater tribal self-government. A combination of executive orders and the Indian Self-Determination and Educational Assistance Act of 1975 finally put federal support for tribal sovereignty on firmer footing. Despite some unsettled issues, a new realm of meaningful tribal sovereignty within the United States was opened up.

This realm remains fairly new and is still incompletely mapped out. I am tempted to say that tribes are now on a new voyage of discovery in search of the most suitable institutions to govern their own affairs, including in the important area of business law and regulation. From an outsider’s perspective, at least, the impetus for this search is simple. In the United States, the bulk of our practical, everyday business law is state, not federal, law. But tribes are sovereign, to varying but significant degrees, with respect to state law. That is, state laws and state legal procedures and institutions often do not apply, or do not clearly apply, to business disputes on reservations. Unless appropriate tribal laws and institutions are in place, the result can be a vacuum, a real or perceived lack of business law and related institutions on reservations. Not surprisingly, this has a chilling effect on business and economic development.

Fortunately, since the 1930s and especially since the 1970s, a number of tribes have pioneered the development of laws and institutions that support growth while respecting tribal traditions. In the Southwest, for example, the Navajo have developed both an extensive body of written law and a strong system of courts to coherently administer a blend of written and Navajo traditional law. Later, I will also discuss work here in Montana. Nonetheless, the voyage has only begun, and much remains to be learned and done.

Our Work

The Minneapolis Fed’s Community Development program is proud to assist in this journey. For many years, we have helped Ninth District tribes explore how to make good use of their renewed sovereign powers, with a special focus on helping tribes develop the legal and institutional foundations of a strong private business sector. This fits neatly into our general strategy of shoring up the foundations of a sound and inclusive market-oriented economy; in fact, I regard it as perhaps the best example of that strategy.

Some of our work in this area goes back many years, but the thrust of our current efforts took shape early in the previous decade here in Montana. Through the initiative of Sue Woodrow, who is our Helena Branch Community Development staff person and an attorney with experience on Indian reservations, we began to take an active role in national efforts to draft model tribal business laws.

What is a model law? It’s essentially a recommended starting point that a legislative body can use in drafting and passing real laws. For example, states often base their business laws on the model laws developed by a voluntary organization called the Uniform Law Commission.

About 10 years ago, the commission took a new direction by undertaking to draft a model secured transactions law for tribal governments. Secured transactions laws are basic to modern business finance. These laws allow a business owner to pledge movable property, like a truck or machine the business owns, as collateral for a loan. State governments have provided for this bread-and-butter business activity by adopting versions of the commission’s Uniform Commercial Code (UCC) for states and, in particular, its Article 9 on secured transactions.

As I’ve noted, however, state law does not automatically extend to transactions on reservations. So unless tribes take similar steps to adopt secured transactions laws, creditors may hold back from making collateralized loans to reservation-based businesses. There are ways to try to work around this problem, and some tribes had adopted varying types of secured transactions laws to fill the gap. Overall, however, big gaps remained, and the existing tribal laws in this area were often incomplete, confusingly divergent, or out of date.

The Uniform Law Commission chose to address this problem head on. Under its leadership, a team of business law experts and tribal leaders gathered to devise a model secured transactions law that would both support collateralized lending on reservations and respect key aspects of tribal sovereignty. The team also understood that an effective model tribal act would need to be free-standing, unlike the UCC’s Article 9, which frequently refers to other UCC articles. We were very pleased to make Sue Woodrow available to serve on this team of experts.

In 2005, after four years of work, the group put forward a new model Tribal Secured Transactions Act, or model STA, for tribal governments to consider. Just as states decide whether to adopt the Uniform Law Commission’s model acts, tribes are free to make use of the model STA as they wish. However, to help tribes make an informed decision, our Community Development program prominently includes the provision of information about the model STA, which we pursue through our publications, a new Indian Country page on our website, and presentations and meetings all around Indian Country.

Since 2005, a growing number of tribes have reached the conclusion that the model STA can help them. Again, the way was paved here in Montana. Crow tribal leaders were involved in advising the Uniform Law Commission on the model act and were also quick to undertake the process of adapting the model act to meet their specific needs. The tribe passed its customized version of the model STA in April 2006. Since then, other tribes in the Ninth District and beyond have adopted versions of the model STA, including the Oglala Sioux in South Dakota, the Mille Lacs and Leech Lake Ojibwe in Minnesota, the Ponca in Nebraska, and the Osage in Oklahoma, while others are actively considering it.

Community Development’s support has not ended with adoption of the tribal STAs, and for good reason. The act is important, but achieving its full potential requires a system for filing liens, judges who are trained to understand and enforce it, and lenders who understand and trust it. To assist tribes in putting these elements in place, our Community Development staff have organized training materials and events on the STAs for tribal judges, lenders, attorneys, and other interested parties. They have also helped tribes negotiate with state governments to use existing state lien filing systems. We were thus very pleased when the compact that was negotiated here, for the Crow tribe to use the state of Montana’s lien filing system, was nationally recognized with a ceremonial signing at the Capitol in Washington, D.C., on February 6, 2008.

Recently, our work in Indian Country has broadened in three new directions that complement our earlier work. First, to assist Indian business owners to articulate and overcome barriers to tribal economic development, the Minneapolis Community Development staff have helped organize Indian business alliances, or IBAs, in Montana, South Dakota, Minnesota, and Wisconsin. These statewide coalitions of tribes, financial institutions, nonprofit organizations, corporations, colleges and universities, and government agencies work to encourage and support Native small business owners and entrepreneurs. Although each alliance is unique, they all have committed to working on four building blocks of sustainable business development in Indian Country: governance, infrastructure, finance, and business training and support resources. The Montana IBA is quite active, and we expect to work with them to host a conference in Montana on tribal economic development issues and opportunities later this year. Similar events with our other IBAs are also in the works this year.

Second, we have again made Sue Woodrow available to the Uniform Law Commission, this time to assist in drafting a model tribal probate code. This project is in its early stages but further exemplifies our support for tribes’ efforts to modernize their legal institutions in support of economic development.

Finally, I have challenged my Community Development staff to evaluate the impact of their efforts to assist tribes in the development of tribal business laws and institutions. Part of their response will be to compare key aspects of the business environment on a number of reservations, in order to assess which factors seem to be associated with better economic outcomes. This is a new and challenging research effort, but I hope we will be able to report some results by next year.

Conclusion

In conclusion, I have noted that Indian tribes have embarked on a voyage of discovery of their renewed sovereign powers and capacity for local governance. Our Community Development program has strongly supported this journey for many years and will continue to do so. As you can see by visiting our website, our Indian Country work fits into a broader strategy that touches Montana and the rest of the Ninth District in many ways. Nonetheless, I regard our work with tribes who are modernizing the legal and institutional foundations of their reservation economies, much of it done right here in Montana, as the leading example of how our Community Development program rounds out the Federal Reserve’s approach to economic policy and economic development.

Thank you.

Thank you, Jacqui, for that introduction. Good afternoon. I am happy to have the opportunity to welcome you to the Federal Reserve Bank of Minneapolis and speak with you today. I assumed the role of president at this Reserve Bank long after the launch of the Emerging Markets Homeownership Initiative, but I have heard about your goals, objectives, challenges, and successes from my community development staff. I understand the purpose of this “lunch ‘n’ learn” session today is to encourage dialogue and brainstorming on the next steps for this initiative in light of the recent economic and housing crisis. I thought I would provide some context for the changes in mortgage lending practices that have followed the housing crisis. As always, I am speaking for myself today, and not others in the Federal Reserve System, including the Federal Open Market Committee. I trust that my comments will prove beneficial in your endeavors.

Let’s turn back the clock for a moment to the second half of 2006. At that time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. (Think, for example, of mortgage-backed securities or any asset backed by mortgage-backed securities.) They viewed those assets as being largely free of risk. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were beginning to learn the hard way that U.S. land was a risky investment. Now the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits. In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it started to become clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors.

As investors became more concerned about the quality of mortgage loans, the secondary market for private-label mortgage-backed securities nearly disappeared. As a result, about 90 percent of mortgages originated over the past two years were guaranteed by government-controlled entities such as Freddie Mac, Fannie Mae, the Federal Housing Authority, or the Veterans Administration. Investors are willing to purchase mortgages and mortgage-backed securities from these agencies mainly because they have faith that the federal government stands behind those instruments.

This heavy reliance on government guarantees is not a sound long-term strategy. Over time, our country needs a mortgage market that returns to greater reliance on private risk-taking and private risk assessment, along with the enhanced regulatory oversight that is already in place. And, in fact, discussions are currently taking place on suitable options for bringing more private capital back into the mortgage market.

Even more generally, I believe that as a country, we need to take this opportunity to rethink many aspects of our public policy programs in the context of housing finance. Home ownership has long been part of the American dream, in no little part because home owners have invested not just in their houses but in their communities. But, through the mortgage interest tax deduction and other programs, we are encouraging people to buy homes by taking on debt—and sometimes large amounts of debt. If we truly want to encourage home ownership, we should contemplate programs that provide incentives for individuals to save and become equity holders in their homes—and, by extension, in their communities.

Conclusion

We have come through a very difficult recession, caused in no little part by the large fall in residential housing prices that took place after 2006. I believe that the size of this shock meant that this recession was going to be a painful and challenging one, regardless of the policy response. Certainly, the Fed has played, and will continue to play, multiple roles in promoting sound, affordable, and accessible housing finance. In our most prominent role as makers of U.S. monetary policy, the Fed is committed to keeping inflation under control, which helps make traditional mortgages more affordable.

The Fed also has a key role in overseeing many of the recent financial reforms aimed at preventing the excessive risk-taking that contributed to soaring home prices, imprudent lending, and ultimately, the housing bust. Our safety and soundness and macro-prudential supervisors will be leaders in applying new regulatory approaches for banks and others.

Finally, as part of our continuing responsibility for implementing the Community Reinvestment Act, our community development unit plans to work with you to develop understanding, institutions, and programs to promote equal access to credit and financial services. I look forward to hearing the results of your discussion groups today, including concrete suggestions for how the Federal Reserve can help via its policies, programs, and research.

Thank you very much.

Sargent and Wallace published their classic “Some Unpleasant Monetarist Arithmetic” in the Minneapolis Fed’s Quarterly Review in 1981. Since that date, there has been a growing appreciation of the role of fiscal policy in the determination of the price level. The idea is a simple one. Consider a government that borrows only using non-indexed debt denominated in its own currency. There is an intertemporal government budget constraint that implies that the current real value of government liabilities — including the monetary base — must equal the present value of future real surpluses. Because the liabilities are nominal and non-indexed, the government budget constraint provides a linkage between the public’s assessment of future real tax collections and government spending and the current price level.

I like John Cochrane’s analogy here.² He thinks of money and government bonds as being like stock in a company. Just like a firm’s stock, money and bonds implicitly represent claims to the ownership of the government’s stream of surpluses. And just like with financial assets, the variations in their prices are fundamentally linked to variations in the present discounted value of government profits — that is, surpluses.³

This simple insight has rather profound consequences for how we think about inflation. Inflation is no longer “always and everywhere a monetary phenomenon”. Instead, even apparently independent central banks may not have control of the price level. Thus, if the public begins to think that the fiscal authority is behaving irresponsibly, that belief will push upward on the price level.

However, in the existing literature, the analysis of fiscal effects on the price level is typically based on the presumption that a fiscal authority will never default on liabilities denominated in its own currency. In my remarks today, I will relax this assumption. Once I do so, it will become clear that a sufficiently tough central bank does have the ability to control the price level, regardless of the behavior of the fiscal authority. ⁴ I will argue that its ability to do so hinges on the nature of its response to the possibility of default on the part of the fiscal authority. I will talk about some of the short-run versus long-run tensions involved in that response. Throughout, I will refer to the central bank as CB and the fiscal authority as FA. I will refer to the currency as being dollars, but that should not be viewed as suggesting that I am talking about the United States — or Australia.

Let me start by describing a simple CB policy: a commodity price peg. Suppose the central bank holds X ounces of gold. It commits to being willing to buy and sell p dollars for each ounce of gold, and has a monetary base of $pX. This policy successfully ties the price level to variations in the price of gold, regardless of the behavior of the FA.

What impact does this policy have on the FA? Now, when the FA borrows in dollars, it is essentially borrowing in a real commodity: gold. All of the FA’s debt is essentially indexed to the price of gold, and it is certainly conceivable that various shocks could lead the FA to default on those obligations.⁵

Of course, as I have argued elsewhere, this simple policy is generally viewed as suboptimal by macroeconomists. ⁶ In contrast, suppose that the CB follows an aggressive Taylor rule when determining the path of the short-term interest rate. ⁷ That policy pins down an inflation path in the usual way, regardless of the FA’s fiscal plans.⁸ However, given that inflation path, the FA’s nominal debt is now actually real. This means that if the FA is faced with an unexpected decline in its current and expected future real surpluses, it will be forced to default.⁹

Thus, once we allow for the possibility of default by the FA, a sufficiently tough CB can have considerable control over the price level. Of course, I’ve been arguing through examples. It would be more interesting to deliver a fuller characterization of the term “sufficiently tough” — but I’m not going to attempt to do so. Instead, in what follows, I’ll discuss some aspects of the CB’s response to a particularly critical situation.

Suppose the FA owes $10 billion on a given Friday. It plans to repay that loan by auctioning new debt on the preceding Monday. However, when it auctions off the new debt, it finds that it can only raise $5 billion. The FA is now in danger of defaulting on its Friday obligation of $10 billion.

It is at this stage that the level of commitment of the CB to its chosen inflation path will be severely tested. The FA will ask the CB to take some action that will allow the FA to raise an additional $5 billion on Wednesday. There are many possible actions. The FA might ask the CB to intervene by setting a floor on the price of debt in the Wednesday auction. But there are less overt approaches. For example, the CB can commit to a price peg for the FA’s debt in the secondary market for that debt.

In any event, if the CB does intervene in some way to ensure the FA’s solvency, the CB no longer can be said to have independent control over the price level. If the CB’s intervention was largely unanticipated by markets, expected inflation will rise after the CB’s intervention. Then, incipient fiscal insolvency has triggered inflationary pressures. Of course, markets may well have already assigned a positive probability to the possibility that the CB might intervene in this kind of scenario. If so, then past inflation was already influenced by the markets’ expectations of this fiscal policy scenario.

Should the CB be required to never intervene in this sort of insolvency scenario? I’ve argued that a ban on these interventions will give the CB more independence in its control over the price level. For those who think of CB independence as being the foundational element of macroeconomic policy, that pretty much settles the question.

But I see a couple of reasons for caution here. It is certainly conceivable that FA insolvency can be triggered by shocks that are well outside of the control of the FA itself. And, empirically, FA insolvency is associated with large short-term and even medium-term declines in output. Should the CB be prepared to drive the FA into insolvency given the possible adverse economic impact on the country?

More subtly, regardless of the FA’s solvency, sovereign debt issues can fail simply through a co-ordination failure among investors. If I, as an investor, don’t anticipate that others will buy into the debt issue, I won’t either. In this sense, sovereign debt issues may be susceptible to suboptimal “runs”. The CB can eliminate this possibility by ensuring the nominal promises of the FA whenever the FA is threatened with default.

Thus, I see trade-offs. On the one hand, the CB is known to be willing to intervene to keep the FA solvent, then inflation is necessarily shaped by fiscal considerations and by the short-run incentives of elected officials. We know from many years of theoretical and empirical research that this effect is not a desirable one. On the other hand, if the CB is fully committed to allow the FA to default if necessary, then even optimal debt management by the FA may end up exposing the country to troubling risks.

Let me wrap up. I’ve argued that even if the fiscal authority borrows exclusively in its country’s own currency, the central bank can have a large amount of control over the price level. But the central bank can only achieve that control if it is willing to commit to letting the fiscal authority default. Such a commitment may expose the country to risks of short-term and medium-term output losses. How this trade-off should best be resolved awaits future research. But I suspect that it may be optimal for central banks to guarantee fiscal authority debts in some situations. If so, we again have to think of price level determination as something that is done jointly by the fiscal authority and the central bank — just as Sargent and Wallace taught us 30 years ago.

Endnotes

References

Atkeson, Andrew, Chari, Varadarajan V. and Patrick J. Kehoe. 2010. “Sophisticated Monetary Policies.” Quarterly Journal of Economics 125, 47-89.

Bassetto, Marco. 2008. “Fiscal Theory of the Price Level,” in Lawrence Blume and Steven Durlauf (eds.), The New Palgrave: A Dictionary of Economics, 2nd edition, 2008, MacMillan: London.

Cochrane, John H. 2005. “Money as Stock.” Journal of Monetary Economics 52, 501-528.

Cochrane, John H. 2011. “Determinacy and Identification with Taylor Rules.” Working paper. University of Chicago, Booth School of Business.

Eaton, Jonathan and Mark Gersovitz. 1987. “Country Risk and the Organization of International Capital Transfer.” NBER Working Paper 2204, April.

Kocherlakota, Narayana. 2011. “It’s a Wonderful Fed,” speech, St. Paul, MN.

Sargent, Thomas and Neil Wallace. 1981. "Some Unpleasant Monetarist Arithmetic." Federal Reserve Bank of Minneapolis Quarterly Review, Fall, 3:3, 1-17.

Paper and slides:^*

Bubbles and Unemployment:
Paper [PDF]

Bubbles and Unemployment:
Slides [PDF]

In the 1970s, the United States experienced high inflation and high unemployment simultaneously. That experience made clear that accommodative monetary policy may not always be an appropriate response to high unemployment. In the intervening thirty years, macroeconomists have engaged in a careful reconsideration of the exact role of monetary policy. The main conclusion of this research is that the primary role for monetary policy is to offset the impact of what economists term nominal rigidities — that is, the sluggish adjustment of prices and inflation expectations to shocks.

With that conclusion in mind, my slides define the natural rate of unemployment to be the unemployment rate u* that would prevail in the absence of any nominal rigidities. To offset nominal rigidities, monetary policy accommodation should track the gap between the observed unemployment rate and u*. The challenge for monetary policymakers is that u* changes over time and is unobservable.

In this speech and the accompanying notes, I ask two questions. First, what can policymakers learn about the current level of u* from the aggregate data on unemployment and vacancies? Second, what other data can be useful in informing policymakers about the current level of u*?

In answering the first question, I apply the canonical Diamond-Mortensen-Pissarides model (for which the three won the Nobel Prize in Economic Science in 2010) to the aggregate data on unemployment and vacancies. I find that the model and data do not provide a definitive measure of u*. Unemployment insurance benefits have increased since December 2007. Firms expect higher taxes and higher input prices. It is possible that these changes in labor market conditions may have been sufficiently large to generate a big increase in u* in the past three years. However, it is also possible that low job creation is largely attributable to nominal rigidities that are generating low demand. In this case, u* will have changed little since December 2007. In the notes that accompany the slides, I show that the resulting possible range for u* is large: from as low as 5.9% to as high as 8.9%.

In terms of the second question about auxiliary information sources, I proceed more heuristically. The basic intuition is that u* is low if high unemployment is being generated by low demand. Hence, I look for information about the current level of demand. I find that business surveys and the current data on inflation both point to u* being low relative to the current unemployment rate.

I conclude that the current accommodative stance of monetary policy is appropriate. However, the Federal Open Market Committee will need to remain vigilant to the possibility of changes in the gap between the unemployment rate and u*.

Labor Markets and Monetary Policy—Presentation Slides [PDF]

Notes on “Labor Markets and Monetary Policy” [PDF]

Endnotes

Thank you very much for that generous introduction, and thanks to the University of Minnesota for the opportunity to address this special group. I was fortunate enough to give the commencement address at the College of Liberal Arts last May. At that time, I stressed to the graduates how their educations were designed to prepare them for a lifetime of learning. I feel sure that such a message would have resonated even more with this group. Indeed, you’ve left your warm homes on a cold February night to engage in exactly that kind of learning—to hear about the economy and the Federal Reserve. And I want you to know that I also look forward to learning from you during our discussion that will follow my remarks.

My speech this evening will have two distinct parts. In the first part, I will discuss my outlook for the economy in 2011. In the second part, I will look back in time to the Great Recession of 2007-09. My discussion will parallel the classic Frank Capra movie, “It’s a Wonderful Life.” In that movie, the hero, George Bailey, is granted the miraculous opportunity to see how other lives would have been affected if he had never existed. I will do the same for the Federal Reserve and describe how I believe the Great Recession of 2007-09 would have unfolded if the Fed did not exist.

As always, I am speaking for myself today, and not others in the Federal Reserve or on the Federal Open Market Committee.

Outlook

In my outlook, I’ll focus on the three variables of most interest to us at the Federal Open Market Committee (FOMC): real gross domestic product (GDP), unemployment, and inflation. My bottom line is that, from the point of view of the macroeconomy, 2011 will be a better year than 2010.

Last week we learned that real GDP, which measures the nation’s production of goods and services adjusted for inflation, grew at a 3.2 percent annual rate during the fourth quarter of 2010. That growth was slightly higher than the average growth of 2.8 percent during the year—that is, from the fourth quarter of 2009 to the fourth quarter of 2010. Output has finally recovered to its prerecession level—it is 0.1 percent above the level of output in the fourth quarter of 2007. However, we cannot celebrate too much. The population of the United States has grown about 2.6 percent from November 2007 through November 2010. This means that real GDP per person is still 2.5 percent lower than its level in the fourth quarter of 2007. Also, historically, real GDP per person in the United States grows at roughly 2 percent per year. Suppose that real GDP per person had grown at that rate over the past three years. Then, real GDP would be 8.5 percent higher in the fourth quarter of 2010 than it actually is. As you will hear, I expect this 8.5 percent differential to change little, if at all, by the end of 2011. The recession has had and will continue to have a large and persistent impact on the U.S. economy.

At the November 2010 FOMC meeting, participants submitted forecasts for real GDP growth in 2011. The central tendency of these forecasts, which omits the lowest three and the highest three, is that real GDP growth would be between 3 percent and 3.6 percent in 2011. However, these forecasts were made before we knew about the tax changes for 2011 that ended up being instituted in December.

Even with the December changes in fiscal policy, I would say that I expect that real GDP growth will probably be closer to 3 percent than 4 percent in 2011. I still see two major headwinds in the U.S. economy. The first is that many households will continue to strive to rebuild their net worth positions in response to past—and possibly future—falls in residential land prices. As I will explain in more detail later, I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery.

The second headwind is related. Many banks in the United States face ongoing issues with asset quality. For example, the FDIC problem-bank list contains over 800 banks. Problem banks are less likely to take the risk of lending to small and/or younger firms and other entrepreneurial activity. Instead, they are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers. Indeed, as the economy improves, I suspect that this headwind will become even more important. In 2010, our information at the Minneapolis Fed indicates that small businesses were reluctant to expand because of ongoing uncertainties about product demand. As a result, their demand for bank financing remained low. In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.

Turning to labor markets, the unemployment rate fell to 9.4 percent in December from 9.8 percent in November. While any decline is welcome news, I do not think this single data point signals a rapid recovery in labor markets. Employment growth remains disappointingly low—nonfarm employment increased by only 103,000 in December.

I think it is important to understand how unemployment fell by 40 basis points from November to December, even though employment growth was relatively low. Here, it’s helpful to recall how the Census Bureau measures unemployment. Every month, the Census Bureau interviews 60,000 households consisting of about 110,000 individuals. The bureau asks a host of questions, but there are two particularly important ones: Have you worked for pay or profit in the past week? If not, have you looked for work in the past four weeks? The former group is counted as the employed. The second group is counted as the unemployed. The sum of these groups is called the labor force. Anyone who answers no to both questions is regarded as being out of the labor force. The unemployment rate is defined to be the fraction of people in the labor force who are unemployed.

This definition means that the unemployment rate can fall in two distinct ways. It can fall through unemployed people becoming employed. Alternatively, it can fall by unemployed people ceasing to look for work. The second channel was significant in shaping the employment picture in December. In that one month, the labor force fell by 260,000—certainly a large move by historical standards. The available data do suggest that most of the unemployed who left the labor force were young. The number of people under the age of 25 in the labor force fell by about 244,000 from November to December. My hope—and expectation—is that many of these people will return to the labor force as the economy improves in 2011.

Nonetheless, I do not believe that either unemployment or employment will improve rapidly in 2011. Startup businesses and other young firms are a key source of employment growth in the early stages of recoveries. As I’ve mentioned earlier, they are likely to find bank financing more challenging to obtain than usual. As well, 4.2 percent of the labor force has been unemployed for longer than six months. Historically, this group of workers has a low job-finding rate.

The central tendency of the November FOMC forecasts is that unemployment will remain above 9 percent throughout 2011. I would agree with those forecasts. Even more troublingly, I expect too that unemployment is likely to be higher than 8 percent as late as the end of 2012.

Finally, I turn to inflation. Inflation was extraordinarily low in 2010. From the fourth quarter of 2009 through the fourth quarter of 2010, headline PCE inflation was 1.2 percent. The term “headline” means that this measure includes both food and energy. But fluctuations in food and energy prices are typically transient and volatile.For this reason, core PCE inflation—inflation measured without food and energy—has historically been a better predictor of future headline PCE inflation than headline PCE inflation itself. Core PCE inflation over 2010 was even lower: only 0.8 percent.

These inflation levels are too low to be consistent with usual formulations of the Fed’s price stability mandate. More troublingly, inflation fell substantially in 2010. From the fourth quarter of 2008 through the fourth quarter of 2009, core PCE inflation was 1.7 percent. Hence, in the course of one year, inflation rates fell by 90 basis points. A further deceleration of the same magnitude in 2011 would drive core PCE inflation into negative territory.

With that said, I’m optimistic that inflation will actually turn north in 2011. Our Minneapolis Fed forecasting model indicates that, over the course of 2011, inflation will be around 1.5 percent. We can get another reading by looking at the prices of financial instruments called zero-coupon inflation-indexed swaps. Their current prices imply that, for the coming year, expected inflation will be roughly 1.7 percent.

To summarize: I expect real output to grow slightly more rapidly in 2011 than in 2010. Household deleveraging and bank asset quality will remain a drag on the recovery. Unemployment will fall—but much more slowly than we would like. Finally, as is suggested by financial market data, I am optimistic that inflation will be higher in 2011 than in 2010, while still remaining under 2 percent.

The Fed’s Responses and Their Benefits

Let me turn now to the second part of my speech. The National Bureau of Economic Research’s business dating committee serves as the official arbiter of recessions. The committee has determined that the Great Recession began in December 2007 and ended in June 2009. During that time period, real GDP fell by 4 percent and unemployment nearly doubled.

The Federal Reserve responded to the Great Recession and the associated financial crisis in a number of ways. These responses fall roughly into two classes. First, the Fed engaged in a vast amount of lending to firms believed to be in sound condition. It lent through conventional vehicles like the discount window and swaps with foreign central banks. But it also lent through relatively unconventional vehicles like the Term Asset-Backed Securities Loan Facility.² I’ll briefly discuss how this lending is distinct from the Fed’s injection of funds into obviously nonsolvent institutions like AIG.

Second, the Fed lowered the real interest rate facing borrowers and lenders.

Here, I should clarify some terminology. By the term “real interest rate,” I’m referring to the interest rate received by lenders net of inflation. Thus, if the interest rate on the loan is 5 percent and lenders expect inflation to be around 2 percent, the real interest rate is roughly 3 percent. Economists generally think that the real interest rate, not the nominal interest rate, matters for economic decision-making.

Early in the recession, the Fed lowered its target for the fed funds rate. Given that inflation expectations remained stable, this action served to lower the real interest rate. By early 2009, when the fed funds target essentially reached its lower bound, the Fed used large-scale asset purchases to achieve further reductions in the real interest rate.

I’ll first discuss the lending responses and then talk about the interest rate cuts. I’ll then discuss how I believe economic events would have unfolded had there been no Fed.

Lending
To understand the Fed’s responses to the events of 2007-09, we need to step back to the second half of 2006. At that point in time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. (Think, for example, of mortgage-backed securities or any asset backed by mortgage-backed securities.) They viewed those assets as being largely free of risk. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were beginning to learn the hard way that U.S. land was a risky investment. Now the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits. In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

I would say that most economists agree about how central banks should respond to financial panics. The crux of that agreed-upon response is that central banks have to be willing to lend freely to solvent firms, against a wide range of good collateral, at some kind of penalty rate. This policy is useful for two reasons. First, it provides a source of funds to potential borrowers who are illiquid but nonetheless solvent. Second, it provides a floor to collateral valuation. Private lenders know that they can always use collateral seized from a defaulting borrower as a vehicle to borrow money from the central bank. That baseline use serves to spur private lending.

Beginning in mid-2007, the Fed took a number of actions consistent with this operating principle. It lent money to financial institutions through the discount window and its close cousin, the Term Auction Facility. It injected liquidity into a broad range of essential credit markets through a veritable alphabet soup of special lending vehicles. In some sense, these interventions were typical for a central bank operating in the context of a financial panic. But the size of the problem meant that the operations were—to an extent—unprecedented in their scale. At their peak, the interventions made up more than a trillion dollars of Federal Reserve assets.

There is no doubt that these interventions saved many solvent firms from collapse during the financial crisis. Over time, panic eased and spreads in financial markets normalized. Once that happened, the private sector stopped borrowing from the Fed because it found the Fed’s penalty rates too onerous. As a result, the Fed was able to shut down its special lending facilities in 2010.

It is plausible that the Fed’s loans through the various special facilities exposed it—and by extension, the American public—to some risk of loss. However, it is difficult to know how much risk was involved. We generally try to measure a financial asset’s risk by the spread between its yield and that of a safe benchmark like U.S. Treasuries. But in a financial panic, a relatively large fraction of such a spread is attributable to illiquidity as opposed to intrinsic risk. The goal of the central bank’s intervention is exactly to eliminate this panic-driven illiquidity. Accordingly, we cannot gauge the Fed’s risk exposures without somehow correcting spreads for this illiquidity factor. This calculation strikes me as a nontrivial one. What we can say is that the Fed has not lost a penny on any of these transactions.

The lending that I’ve described differs greatly from the institution-specific assistance the Federal Reserve provided to firms like AIG. These institution-specific interventions were deemed necessary by the Fed and the Bush administration because of deficiencies in the existing resolution regime for systemically important financial institutions. The Dodd-Frank Act addresses these deficiencies. Simultaneously—and correctly—the Dodd-Frank Act removes the Fed’s ability to engage in institution-specific assistance. The act does leave in place the Fed’s ability to engage in broad-based market interventions of the kind that I’ve described, albeit with more congressional and White House oversight.

Cutting Interest Rates
I’ve talked about how the fall in land prices generated a sharp increase in risk perceptions in financial markets, and how that in turn led to a financial crisis. I now want to turn to what I see as the second key effect of the fall in land prices. This fall reduced the net worth of many households and firms.³ They responded by forgoing consumption and investment projects. The fall in household demand for consumption and firm demand for investment led in turn to a fall in output and employment,⁴ and put downward pressure on the price level.

The FOMC reacted by lowering its target interest rate from 5.25 percent in August 2007 to a range of 0-25 basis points in December 2008. Since inflation expectations remained stable, the FOMC’s action has the effect of lowering the real interest rate facing households. Households respond by saving less and demanding more consumption. Similarly, firms undertake more investment projects. In this way, the FOMC can partially offset the impact on the economy of the loss of net worth.

Lowering rates, of course, may lead to undesirable inflationary pressures within the economy. However, the recent path of inflation shows little evidence of such pressures. From the fourth quarter of 2006 through the fourth quarter of 2007, core PCE inflation was 2.4 percent. As I mentioned earlier, core inflation from the fourth quarter of 2009 to the fourth quarter of 2010 was considerably lower at only 0.8 percent. The fall in headline PCE inflation (which includes food and energy) has been even more dramatic: from 3.5 percent down to 1.2 percent.

Indeed, given the fall in inflation and the high rate of unemployment, the FOMC would probably have liked to respond by cutting its target interest rate still further. The problem is that the target interest rate is essentially at zero and cannot go negative. Instead, from December 2008 through March 2010, and again beginning in November 2010, the FOMC engaged in large-scale purchases of long-term Treasuries. The goal of these transactions is to lower long-term real interest rates and again offset the impact on the economy of the net worth shock.

Thus, the fall in land prices triggered an increase in risk perceptions and a decrease in household net worth. The increase in risk led to a major financial crisis that has been cured, thanks in no little part to actions by the Federal Reserve. The decrease in net worth led to a major recession and ongoing slow recovery. The Federal Reserve’s reduction in interest rates has lessened the impact of the net worth shock.

George—Meet Clarence
But now I turn to the hypothetical posed in the last third of “It’s a Wonderful Life.” Suppose that there were no Fed. What would have happened to the U.S. economy in the past three years?

The Federal Reserve’s key power is that it has the ability to adjust the size of what’s called the monetary base. The monetary base has two components. The first component is currency—the bills and coins that we use for transactions. The second component consists of what’s called “bank reserves.” These are essentially the deposits that various banks hold with the Fed. The Fed has expanded the monetary base by more than 100 percent from September 2008 through the end of 2010. To me, an America without a Fed means an America in which the monetary base is fixed in size.

So, suppose the monetary base had been fixed in the past three years at its December 2007 level. What would have happened? One consequence is immediate. The Federal Reserve funded its various lending programs by creating large amounts of bank reserves. If the monetary base were fixed in size, the Fed could not have created those lending initiatives. As a result, many more solvent financial institutions would have failed during the financial panic.

More subtly, the limitation on the size of the monetary base would have made currency and bank reserves scarcer after 2007. Their scarcity would make these monetary assets more valuable in a couple of senses. First, they would have been more valuable relative to other financial assets. That means bond prices would have been lower and so bond yields higher. Second, currency and bank reserves would have been more valuable relative to consumer goods. Hence, expected inflation and realized inflation would have been lower over the past three years.

Higher bond yields and lower expected inflation work together to imply that households and firms would have faced higher real interest rates. Their demand for consumption and investment would have been lower. Thus, if the Federal Reserve could not have adjusted the monetary base upward, real GDP would have fallen by even more than 4 percent and unemployment would have been well above 10 percent.

As with any counterfactual, these ruminations are necessarily conjectural. But there are data to support them. In the early years of the Great Depression, the United States was on the gold standard and the Fed could not easily adjust the quantity of bank reserves. As a result, the Fed did not engage in broad-based lending during the 1929-33 period. Nor did it cut interest rates aggressively. By 1933, hosts of financial institutions had failed, real GDP had fallen by over 25 percent, unemployment was 25 percent, and the nation had experienced annual double-digit rates of deflation. The Fed’s passiveness in 1929-33 was associated with an economic catastrophe. Many scholars—including Milton Friedman and Fed Chairman Ben Bernanke—have argued that much of this association should in fact be viewed as causal.

Did the Fed Cause the Bubble?
My version of “It’s a Wonderful Life” may strike some as incomplete because it starts in 2007. Those listeners might ask: Was the land price appreciation in the United States in the early 2000s due to the Fed’s low interest rate policy? If so, we might have to recast the Fed as being more akin to the unfortunate Uncle Billy than to George.

But my answer to this query would be no. The problem for this story is that land prices actually started to grow at a surprisingly fast rate when the Fed was following a relatively tight policy. To be concrete, from 1975 to 1996, land prices grew in real terms at less than 2 percent per year. In contrast, from 1996 to 2001, land prices grew by 11 percent per year in real terms, while the Fed maintained its target interest rate between 4.75 percent and 6.5 percent.⁵ This is hardly considered to be loose monetary policy, especially given that the economy was entering recession toward the end of this period. It is true that the rate of growth of land prices did accelerate still further—to 17 percent per year—in the next five years. But I think that the data clearly say that the fast rate of growth in U.S. land prices—what’s sometimes called a “bubble” in land prices—originally started in 1996, without any obvious change in Fed policy.

I have to say that this lack of an empirical connection is not surprising to me. At least at present, there is little or no economic theory to support a connection between monetary policy, as typically conducted in the United States, and bubble formation.⁶

But, if not the Fed, what or who was responsible for the high price of U.S. residential land? My views are more agnostic on this point. I have heard several plausible stories. In general, though, I think that the stories tend to be overly focused on the United States in the 2000s. We saw large run-ups in land prices, followed by large falls in land prices, in many other parts of the world in the 2000s. And these episodes have recurred repeatedly throughout history. We need to develop macroeconomic models and modes of thought that can successfully confront this broader scope of economic data.

Conclusion

Let me wrap up. We have come through a very difficult recession, caused in no little part by the large fall in land prices that took place after 2006. I believe that the size of this shock meant that this recession was going to be a painful and challenging one, regardless of the policy response. Nonetheless, it is clear to me that the recession and its subsequent recovery would have been significantly worse in the absence of the actions of the Federal Reserve.

Now, we have a couple of choices. We can conclude as in “It’s a Wonderful Life,” and I can lead you in a rousing chorus of “Auld Lang Syne.” Or we can start taking questions. As with any choice, I’m sure that you find the trade-offs daunting. Nonetheless, those who know my singing talents well will tell you: We should move to questions.

Thank you very much.

Endnotes

References

Heathcote, Jonathan, and Morris A. Davis. 2007. “The Price and Quantity of Residential Land in the United States.” Journal of Monetary Economics 54 (November), pp. 2595-2620.

Kocherlakota, Narayana R. 2010. “Two Models of Land Overvaluation and Their Implications.” Presented at “A Return to Jekyll Island: The Origins, History, and Future of the Federal Reserve,” Jekyll Island, Ga.

Willardson, Niel. 2008. “Actions to Restore Financial Stability.” The Region (December), Federal Reserve Bank of Minneapolis.

Willardson, Niel, and LuAnne Pederson. 2010. “Federal Reserve Liquidity Programs: An Update.” The Region (June), Federal Reserve Bank of Minneapolis.

Thank you very much for that generous introduction, and thanks to the Wisconsin Bankers Association for the invitation to join you here today. I’ve visited Madison several times, and I’ve always enjoyed the experience. I’ve always felt that Madison and the Twin Cities are pretty similar as a pair of state capitals with beautiful water views and great universities. Of course, at that level, they sound a lot like Venice, Italy.

My speech today will have two distinct parts. In the first part, I will discuss my outlook for the economy in 2011. In the second part, I will look back in time to the Great Recession of 2007-09. My discussion will parallel the classic Frank Capra movie, “It’s a Wonderful Life.” In that movie, the hero, George Bailey, is granted the miraculous opportunity to see how other lives would have been affected if he had never existed. I will do the same for the Federal Reserve and describe how I believe the Great Recession of 2007-09 would have unfolded if the Fed did not exist.

As always, I am speaking for myself today, and not others in the Federal Reserve.

Outlook

In my outlook, I’ll focus on the three variables of most interest to us at the Federal Open Market Committee (FOMC): real gross domestic product (GDP), unemployment, and inflation. My bottom line is that, from the point of view of the macroeconomy, 2011 will be a better year than 2010.

In the first three quarters of 2010, real GDP growth averaged 2.7 percent at an annualized rate. We don’t have a fourth quarter number yet, but I expect that it will be higher. With that in mind, I expect that real GDP grew at a rate of around 2.8 percent from the fourth quarter of 2009 to the fourth quarter of 2010. If that prediction ends up being right, real GDP will—finally—recover to its level in the fourth quarter of 2007.

However, we cannot celebrate too much. The population of the United States has grown about 2.6 percent from November 2007 through November 2010. This means that real GDP per person is still 2.6 percent lower than its level in the fourth quarter of 2007. Also, historically, real GDP per person in the United States grows at roughly 2 percent per year. Suppose that real GDP per person had grown at that rate over the past three years. Then, real GDP would be 8.6 percent higher in the fourth quarter of 2010 than it actually is. As you will hear, I expect this 8.6 percent differential to change little, if at all, by the end of 2011. The recession has had and will continue to have a large and persistent impact on the U.S. economy.

At the November 2010 FOMC meeting, participants submitted forecasts for real GDP growth in 2010. The central tendency of these forecasts, which omits the lowest three and the highest three, is that real GDP growth would be between 3 percent and 3.6 percent in 2011. However, these forecasts were made before we knew about the tax changes for 2011 that ended up being instituted in December.

Even with the December changes in fiscal policy, I would say that I expect that real GDP growth will probably be closer to 3 percent than 4 percent in 2011. I still see two major headwinds in the U.S. economy. The first is that many households will continue to strive to rebuild their net worth positions in response to past—and possibly future—falls in residential land prices. As I will explain in more detail later, I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery.

The second headwind is related. Many banks in the United States face ongoing issues with asset quality. For example, the FDIC problem bank list contains over 800 banks. Problem banks are less likely to take the risk of lending to small and/or younger firms and other entrepreneurial activity. Instead, they are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers. Indeed, as the economy improves, I suspect that this headwind will become even more important. In 2010, our information at the Minneapolis Fed indicates that small businesses were reluctant to expand because of ongoing uncertainties about product demand. As a result, their demand for bank financing remained low. In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.

Employment data released last Friday indicated that the unemployment rate fell to 9.4 percent in December from 9.8 percent in November. While any decline is welcome news, I do not think this single data point signals a rapid recovery in labor markets. Employment growth remains disappointingly low—nonfarm employment increased by only 103,000 in December.

I think that it is important to understand how unemployment fell by 40 basis points from November to December, even though employment growth was relatively low. Here, it’s helpful to recall how the Census Bureau measures unemployment. Every month, the Census Bureau interviews 60,000 households consisting of about 110,000 individuals. The bureau asks a host of questions, but there are two particularly important ones: Have you worked for pay or profit in the past week? If not, have you looked for work in the past four weeks? The former group is counted as the employed. The second group is counted as the unemployed. The sum of these groups is called the labor force. Anyone who answers no to both questions is regarded as being out of the labor force. The unemployment rate is defined to be the fraction of people in the labor force who are unemployed.

This definition means that the unemployment rate can fall in two distinct ways. It can fall through unemployed people becoming employed. Alternatively, it can fall by unemployed people ceasing to look for work. The second channel was significant in shaping the employment picture in December. In that one month, the labor force fell by 260,000—certainly a large move by historical standards. The available data do suggest that most of the unemployed who left the labor force were young. The number of people under the age of 25 in the labor force fell by about 244,000 from November to December. My hope—and expectation—is that many of these people will return to the labor force as the economy improves in 2011.

Nonetheless, I do not believe that either unemployment or employment will improve rapidly in 2011. Startup businesses and other young firms are a key source of employment growth in the early stages of recoveries. As I’ve mentioned earlier, they are likely to find bank financing more challenging to obtain than usual. As well, 4.2 percent of the labor force has been unemployed for longer than six months. Historically, this group of workers has a low job-finding rate.

The central tendency of the November FOMC forecasts is that unemployment will remain above 9 percent throughout 2011. I would agree with those forecasts. Even more troublingly, I expect too that unemployment is likely to be higher than 8 percent as late as the end of 2012.

Finally, I turn to inflation. Inflation remains extraordinarily low. In the third quarter of 2010, overall PCE inflation—including all goods—was 0.8 percent. Core PCE inflation—stripping away energy and food—was 50 basis points. PCE food inflation was 26 basis points. And all of these figures are annualized.

These inflation levels are too low to be consistent with usual formulations of the Fed’s price stability mandate. More troublingly, inflation continued to trend downward in 2010. In the third quarter of 2009, annualized core PCE inflation was 1.5 percent. Hence, in the course of one year, quarterly inflation rates fell by 100 basis points. A further deceleration of the same magnitude in 2011 would drive inflation into negative territory.

With that said, I’m optimistic that inflation will actually turn north in 2011. Our Minneapolis Fed forecasting model predicts that, by the end of 2011, inflation will be between 1.5 and 2 percent. We can get another reading by looking at the prices of financial instruments called zero-coupon inflation-indexed swaps. Their current prices imply that, for the coming year, expected inflation will be roughly 1.7 percent.

To summarize: I expect that real output will grow slightly more rapidly in 2011 than in 2010. Household deleveraging and bank asset quality will remain a drag on the recovery. Unemployment will fall—but much more slowly than we would like. Finally, as is suggested by financial market data, I am optimistic that we will see some re-inflation in the coming year.

The Fed’s Responses and Their Benefits

Let me turn now to the second part of my speech. The National Bureau of Economic Research’s business dating committee serves as the official arbiter of recessions. The committee has determined that the Great Recession began in December 2007 and ended in June 2009. During that time period, real GDP fell by 4 percent and unemployment nearly doubled.

The Federal Reserve responded to the Great Recession and the associated financial crisis in a number of ways. These responses fall roughly into two classes. First, the Fed engaged in a vast amount of lending to firms believed to be in sound condition. It lent through conventional vehicles like the discount window and swaps with foreign central banks. But it also lent through relatively unconventional vehicles like the Term Asset-Backed Securities Loan Facility.² I’ll briefly discuss how this lending is distinct from the Fed’s injection of funds into obviously nonsolvent institutions like AIG.

Second, the Fed lowered the real interest rate facing borrowers and lenders.

Here, I should clarify some terminology. By the term “real interest rate,” I’m referring to the interest rate received by lenders net of inflation. Thus, if the interest rate on the loan is 5 percent and lenders expect inflation to be around 2 percent, the real interest rate is roughly 3 percent. Economists generally think that the real interest rate, not the nominal interest rate, matters for economic decision-making.

Early in the recession, the Fed lowered its target for the fed funds rate. Given that inflation expectations remained stable, this action served to lower the real interest rate. By early 2009, when the fed funds target essentially reached its lower bound, the Fed used large-scale asset purchases to achieve further reductions in the real interest rate.

I’ll first discuss the lending responses and then talk about the interest rate cuts. I’ll then discuss how I believe economic events would have unfolded had there been no Fed.

Lending
To understand the Fed’s responses to the events of 2007-09, we need to step back to the second half of 2006. At that point in time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. (Think, for example, of mortgage-backed securities or any asset backed by mortgage-backed securities.) They viewed those assets as being largely free of risk. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were beginning to learn the hard way that U.S. land was a risky investment. Now the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits. In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

I would say that most economists agree about how central banks should respond to financial panics. The crux of that agreed-upon response is that central banks have to be willing to lend freely to solvent firms, against a wide range of good collateral, at some kind of penalty rate. This policy is useful for two reasons. First, it provides a source of funds to potential borrowers who are illiquid but nonetheless solvent. Second, it provides a floor to collateral valuation. Private lenders know that they can always use collateral seized from a defaulting borrower as a vehicle to borrow money from the central bank. That baseline use serves to spur private lending.

Beginning in mid-2007, the Fed took a number of actions consistent with this operating principle. It lent money to financial institutions through the discount window and its close cousin, the Term Auction Facility. It injected liquidity into a broad range of essential credit markets through a veritable alphabet soup of special lending vehicles. In some sense, these interventions were typical for a central bank operating in the context of a financial panic. But the size of the problem meant that the operations were—to an extent—unprecedented in their scale. At their peak, the interventions made up more than a trillion dollars of Federal Reserve assets.

There is no doubt that these interventions saved many solvent firms from collapse during the financial crisis. Over time, panic eased and spreads in financial markets normalized. Once that happened, the private sector stopped borrowing from the Fed because it found the Fed’s penalty rates too onerous. As a result, the Fed was able to shut down its special lending facilities in 2010.

It is plausible that the Fed’s loans through the various special facilities exposed it—and by extension, the American public—to some risk of loss. However, it is difficult to know how much risk was involved. We generally try to measure a financial asset’s risk by the spread between its yield and that of a safe benchmark like U.S. Treasuries. But in a financial panic, a relatively large fraction of such a spread is attributable to illiquidity as opposed to intrinsic risk. The goal of the central bank’s intervention is exactly to eliminate this panic-driven illiquidity. Accordingly, we cannot gauge the Fed’s risk exposures without somehow correcting spreads for this illiquidity factor. This calculation strikes me as a nontrivial one. What we can say is that the Fed has not lost a penny on any of these transactions.

The lending that I’ve described differs greatly from the institution-specific assistance the Federal Reserve provided to firms like AIG. These institution-specific interventions were deemed necessary by the Fed and the Bush administration because of deficiencies in the existing resolution regime for systemically important financial institutions. The Dodd-Frank Act addresses these deficiencies. Simultaneously—and correctly—the Dodd-Frank Act removes the Fed’s ability to engage in institution-specific assistance. The act does leave in place the Fed’s ability to engage in broad-based market interventions of the kind that I’ve described, albeit with more congressional and White House oversight.

Cutting Interest Rates
I’ve talked about how the fall in land prices generated a sharp increase in risk perceptions in financial markets, and how that in turn led to a financial crisis. I now want to turn to what I see as the second key effect of the fall in land prices. This fall reduced the net worth of many households and firms.³ They responded by forgoing consumption and investment projects. The fall in household demand for consumption and firm demand for investment led in turn to a fall in output and employment,⁴ and put downward pressure on the price level.

The FOMC reacted by lowering its target interest rate from 5.25 percent in August 2007 to a range of 0-25 basis points in December 2008. Since inflation expectations remained stable, the FOMC’s action has the effect of lowering the real interest rate facing households. Households respond by saving less and demanding more consumption. Similarly, firms undertake more investment projects. In this way, the FOMC can partially offset the impact on the economy of the loss of net worth.

Lowering rates, of course, may lead to undesirable inflationary pressures within the economy. However, the recent path of inflation shows little evidence of such pressures. On a year-over-year basis, core PCE inflation was running about 2.5 percent in the fourth quarter of 2007. It is now down to about 1 percent.

Indeed, given the ongoing deceleration in inflation and the high rate of unemployment, the FOMC would probably have liked to respond by cutting its target interest rate still further. The problem is that the target interest rate is essentially at zero and cannot go negative. Instead, from December 2008 through March 2010, and again beginning in November 2010, the FOMC engaged in large-scale purchases of long-term Treasuries. The goal of these transactions is to lower long-term real interest rates and again offset the impact on the economy of the net worth shock.

Thus, the fall in land prices triggered an increase in risk perceptions and a decrease in household net worth. The increase in risk led to a major financial crisis that has been cured, thanks in no little part to actions by the Federal Reserve. The decrease in net worth led to a major recession and ongoing slow recovery. The Federal Reserve’s reduction in interest rates has lessened the impact of the net worth shock.

George—Meet Clarence
But now I turn to the hypothetical posed in the last third of “It’s a Wonderful Life.” Suppose that there were no Fed. What would have happened to the U.S. economy in the past three years?

The Federal Reserve’s key power is that it has the ability to adjust the size of what’s called the monetary base. The monetary base has two components. The first component is currency—the bills and coins that we use for transactions. The second component consists of what’s called “bank reserves.” These are essentially the deposits that various banks hold with the Fed. The Fed has expanded the monetary base by more than 100 percent from September 2008 through the end of 2010. To me, an America without a Fed means an America in which the monetary base is fixed in size.

So, suppose the monetary base had been fixed in the past three years at its December 2007 level. What would have happened? One consequence is immediate. The Federal Reserve funded its various lending programs by creating large amounts of bank reserves. If the monetary base were fixed in size, the Fed could not have created those lending initiatives. As a result, many more solvent financial institutions would have failed during the financial panic.

More subtly, the limitation on the size of the monetary base would have made currency and bank reserves scarcer after 2007. Their scarcity would make these monetary assets more valuable in a couple of senses. First, they would have been more valuable relative to other financial assets. That means bond prices would have been lower and so bond yields higher. Second, currency and bank reserves would have been more valuable relative to consumer goods. Hence, expected inflation and realized inflation would have been lower over the past three years.

Higher bond yields and lower expected inflation work together to imply that households and firms would have faced higher real interest rates. Their demand for consumption and investment would have been lower. Thus, if the Federal Reserve could not have adjusted the monetary base upward, real GDP would have fallen by even more than 4 percent and unemployment would have been well above 10 percent.

As with any counterfactual, these ruminations are necessarily conjectural. But there are data to support them. In the early years of the Great Depression, the United States was on the gold standard and the Fed could not easily adjust the quantity of bank reserves. As a result, the Fed did not engage in broad-based lending during the 1929-33 period. Nor did it cut interest rates aggressively. By 1933, hosts of financial institutions had failed, real GDP had fallen by over 25 percent, unemployment was 25 percent, and the nation had experienced annual double-digit rates of deflation. The Fed’s passiveness in 1929-33 was associated with an economic catastrophe. Many scholars—including Milton Friedman and Chairman Ben Bernanke—have argued that much of this association should in fact be viewed as causal.

Did the Fed Cause the Bubble?
My version of “It’s a Wonderful Life” may strike some as incomplete because it starts in 2007. Those listeners might ask: Was the land price appreciation in the United States in the early 2000s due to the Fed’s low interest rate policy? If so, we might have to recast the Fed as being more akin to the unfortunate Uncle Billy than to George.

But my answer to this query would be no. The problem for this story is that land prices actually started to grow at a surprisingly fast rate when the Fed was following a relatively tight policy. To be concrete, from 1975 to 1996, land prices grew in real terms at less than 2 percent per year. In contrast, from 1996 to 2001, land prices grew by 11 percent per year in real terms, while the Fed maintained its target interest rate between 4.75 percent and 6.5 percent.⁵ This is hardly considered to be loose monetary policy, especially given that the economy was entering recession toward the end of this period. It is true that the rate of growth of land prices did accelerate still further—to 17 percent per year—in the next five years. But I think that the data clearly say that the fast rate of growth in U.S. land prices—what’s sometimes called a “bubble” in land prices—originally started in 1996, without any obvious change in Fed policy.

I have to say that this lack of an empirical connection is not surprising to me. At least at present, there is little or no economic theory to support a connection between monetary policy, as typically conducted in the United States, and bubble formation.⁶

But, if not the Fed, what or who was responsible for the high price of U.S. residential land? My views are more agnostic on this point. I have heard several plausible stories. In general, though, I think that the stories tend to be overly focused on the United States in the 2000s. We saw large run-ups in land prices, followed by large falls in land prices, in many other parts of the world in the 2000s. And these episodes have recurred repeatedly throughout history. We need to develop macroeconomic models and modes of thought that can successfully confront this broader scope of economic data.

Conclusion

Let me wrap up. We have come through a very difficult recession, caused in no little part by the large fall in land prices that took place after 2006. I believe that the size of this shock meant that this recession was going to be a painful and challenging one, regardless of the policy response. Nonetheless, it is clear to me that the recession and its subsequent recovery would have been significantly worse in the absence of the actions of the Federal Reserve.

Now, we have a couple of choices. We can wrap up as in “It’s a Wonderful Life,” and I can lead you in a rousing chorus of “Auld Lang Syne.” Or we can start taking questions. As with any choice, I’m sure that you find the trade-offs daunting. Nonetheless, those who know my singing talents well will tell you: We should move to questions.

Thank you very much.

Endnotes

References

Kocherlakota, Narayana R. 2010. “Two Models of Land Overvaluation and Their Implications.” Presented at “A Return to Jekyll Island: The Origins, History, and Future of the Federal Reserve,” Jekyll Island, Ga.

Willardson, Niel. 2008. “Actions to Restore Financial Stability.” The Region (December), Federal Reserve Bank of Minneapolis.

Willardson, Niel, and LuAnne Pederson. 2010. “Federal Reserve Liquidity Programs: An Update.” The Region (June), Federal Reserve Bank of Minneapolis.

Thank you very much for that generous introduction. It is a pleasure and an honor to be with you here today and to address this symposium established to commemorate the professional careers and the intellectual interests of Howard and Darrel Alkire, who have meant so much to Hamline University. It is especially an honor to give this talk knowing the prestigious line-up of speakers that precedes me, including Nobel laureate economists and prominent policymakers.

I became president of the Federal Reserve Bank of Minneapolis last October. During the preceding 22 years, I was a professor of economics at a variety of institutions. I did research in a number of areas, including public finance. My main area of interest, though, was macroeconomics. There has been a lot of conversation over the past year or two about what we have and haven’t learned from macroeconomics. For myself, I believe that one of the most important developments in the field is the use of tools from public finance to answer key macroeconomic policy questions. To my knowledge, this line of research dates back to the work of Robert Lucas and Nancy Stokey in the 1980s. It continues to be a vital area of investigation almost 30 years later—and it will play a key role in my remarks today.

I’ll begin by discussing current macroeconomic conditions and the Federal Open Market Committee’s recent actions taken in response to those conditions. That discussion will make clear that the committee took those actions because it is not able to cut its interest rate target any further. Motivated by this difficulty, I will pose and answer the following question: What actions can other policymakers take to approximate the impact of an interest rate cut? In addressing this question, I will rely on recent research being done at the Federal Reserve Bank of Minneapolis by staff researcher Juan Pablo Nicolini and several co-authors. Throughout, I’ll be speaking on behalf of myself and no other participant in FOMC meetings.

Let me start with some basic context about how monetary policy gets made in the United States. The Federal Open Market Committee meets eight times per year to determine the path of monetary policy over the next six to seven weeks. The governors of the Federal Reserve Board and the president of the Federal Reserve Bank of New York are permanent members of the committee. Four other presidents of Reserve banks are on the committee, but this group rotates annually. While they do not vote, the other presidents are invited to the FOMC meeting and contribute to the committee’s deliberations. Right now, I’m a meeting participant, but I will rotate onto the committee in 2011.

The foundation of the committee’s discussions is what is called its dual mandate. By statute, the Federal Reserve is required to follow policies that promote effectively the goals of price stability and maximum employment. The former objective of price stability is generally understood as keeping inflation in a range of around 1.5 to 2.5 percent. The second part of the mandate—maximum employment—is more of a moving target, because employment is shaped by many determinants beyond the Fed’s control: demographics, social custom, taxes, technology, and so on.

With that context, let me describe the economic situation that confronted the committee at its meeting in November. Over the first three quarters of this year, personal consumption expenditure (PCE) price inflation has averaged roughly 1 percent at an annualized rate. This rate is low relative to the FOMC’s target of 2 percent. More troublingly, the inflation rate is drifting downward. Over the preceding two-year period (from the fourth quarter of 2007 through the fourth quarter of 2009), PCE inflation averaged 1.6 percent per year. Just to be clear, the measure of PCE inflation that I’m describing includes all goods, including food and energy.

At the same time, unemployment is high: In October, it was 9.6 percent. Here, too, the trend is not comforting. The recession officially ended in June 2009, and in that month, unemployment was 9.5 percent. Unemployment has actually risen slightly during the course of the recovery.

Sufficient growth in output can steadily lower unemployment. But growth has been low in this recovery compared with most. As I mentioned, the recession officially ended in June 2009 and so has been over for five quarters. Over those five quarters, real gross domestic product (GDP) has grown at an annualized rate of 2.9 percent. More troublingly, growth has been decelerating: In the past two quarters, it has averaged 2.1 percent at an annualized rate. And here, I should note that I’m reporting data on real GDP growth that have actually been revised upward since the November meeting.

This is the economic situation that confronted the FOMC in its November meeting. Inflation and employment are both too low, and the rate of improvement in these variables is too slow. Economic growth has been low and has recently decelerated still further. I think it is safe to say that, given this situation, the FOMC would have liked to have been able to cut its target interest rate. But this option is not available. The FOMC’s target interest rate is already essentially at zero (more precisely, in a range between 0 and 25 basis points).

But the FOMC does have another policy instrument available: its balance sheet. As of the beginning of this month, the FOMC had a portfolio of roughly $2.3 trillion. Over 2 trillion of those dollars are invested in Treasury securities or government-backed securities issued by Fannie Mae, Freddie Mac, and other government-sponsored enterprises. At its November 3 meeting, the FOMC announced that it plans to buy $600 billion of long-term Treasuries in the open market by mid-2011. In exchange for those securities, it will credit the sellers’ accounts at the Fed with more reserves. This kind of action is known as quantitative easing, or QE.

The main goal of QE is to lower the long-run real interest rate. Here, by real interest rate, I’m referring to the interest rate net of expected inflation. More specifically, suppose that the interest rate on a 10-year bond is about 2.5 percent and that people expect inflation to be around 2 percent per year over the next 10 years. Then, the real interest rate is about 0.5 percent per year for the next 10 years.

A low long-term real interest rate stimulates an economy in a number of ways. It spurs consumer spending by allowing consumers to borrow and refinance more cheaply. It makes capital expenditures and hiring more profitable for corporations. Stock prices and house prices rise because those assets become relatively more attractive as investments. Households with these assets become wealthier and demand more consumption. All of these effects should lead to less unemployment and upward pressure on prices.

How does QE go about lowering long-term real interest rates? QE is a sufficiently novel monetary policy tool that different economists may well give different answers to this question. In my view, QE lowers long-term real interest rates in two distinct ways. The first is that QE is a form of nonverbal communication about the FOMC’s future plans. Here’s what I mean. The November FOMC statement says that the committee will keep the fed funds target range exceptionally low for as long as economic conditions warrant. The statement also predicts that exceptionally low fed funds rates are likely to be warranted for an “extended period” of time. In this way, the statement provides explicit communication about the FOMC’s future plans for short-term rates and so also shapes the level of current longer-term interest rates.

QE provides a significant supplement to this explicit verbal communication. The use of QE indicates that the FOMC is likely to keep its target interest rate lower for an even longer period of time. Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.

Thus, QE lowers long-term real interest rates by signaling the FOMC’s intentions about future short-term rates. However, QE also lowers long-term real interest rates in a second, more direct, way. The holder of a long-term Treasury is exposed to interest rate risk, because the value of that bond fluctuates as interest rates vary. When the Fed buys $600 billion of long-term bonds, the bond portfolio of the private sector is now less exposed to this kind of risk. As a consequence, private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, and all long-term yields fall.

In this way, the change to the asset side of the Fed’s balance sheet provides stimulus to the economy. But what about the liability side of its balance sheet? QE creates more reserves in banks’ accounts with the Fed. The standard intuition is that this kind of reserve creation is inflationary. Banks can only offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. More money chasing the same amount of goods—voila, inflation.

Given some of the criticisms of the Fed that have been voiced over the past two weeks, it is important to understand that this basic logic isn’t valid in current circumstances. Banks have nearly $1 trillion of excess reserves. This means that they are not using a lot of their existing licenses to create money. QE gives them $600 billion of new licenses to create money, but I do not see why they would suddenly start to use the new ones if they weren’t using the old ones.

Some observers have expressed concerns that $1 trillion—which will shortly become over $1.5 trillion—of excess reserves represent what they term “kindling” for some future inflationary fire. I believe that these concerns are misplaced for two reasons. First, the Fed has several tools with which to combat incipient inflationary pressures. Most obviously, it can raise the interest rate on excess reserves as a form of tightening. Second, in recent public statements, Chairman Ben Bernanke has explicitly and firmly committed the FOMC to maintaining low inflation. To use his exact words, he said that he has “rejected any notion that we are going to try to raise inflation to a super-normal level.”

As I mentioned before, I do not currently vote on FOMC decisions. I did express support for the FOMC’s decision at the recent meeting. I believe that QE is a move in the right direction. However, as I have discussed on earlier occasions, I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible to cut the target rate any further.

Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative.² Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.

In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay.³ The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut.

It’s useful to explain the underlying mechanism using the kind of example that all Econ I students know and loathe—I mean, love. Suppose widgets cost $1 each in 2011. Suppose, too, that you can earn 1 percent interest over the coming year, but that inflation is also expected to be 1 percent. With that interest rate, and that inflation rate, any dollar that you save from 2011 into 2012 can also buy a widget. So, with each dollar, you face the trade-off of buying a widget today or buying a widget next year.

Next, let’s understand how an interest rate cut affects this baseline trade-off. Suppose the Fed were able to cut its target interest rate by 100 basis points, without affecting expected inflation all that much. The bank would pass that interest rate cut along, and that means that your bank interest rate would fall from 1 percent to zero. Widgets still cost $1 in 2011, and they still cost $1.01 in 2012. But with the interest rate of zero, you would now have to save $1.01 to be able to buy a widget in 2012. The cut in the interest rate has made buying widgets in 2011 cheaper relative to buying widgets in 2012.

Thus, if the Fed were able to cut its target interest rate, saving would become less attractive and borrowing more attractive. Consumers would demand more widgets today. Firms would hire workers to produce more widgets today. Unemployment would decline.

But now let’s go back to the benchmark case without the interest rate cut. Recall that expected inflation is 1 percent and that your bank is paying you an interest rate of 1 percent. In that context, think about the three-pronged fiscal policy change that I described earlier. The first part is that the fiscal authorities institute a 1 percent tax on consumption goods that starts in 2012 and lasts for the foreseeable future. Widgets still cost $1 in 2011. Inflation is 1 percent and the tax is 1 percent, and so widgets cost $1.02 in 2012. Given the interest rate of 1 percent, you must save $1.01 in 2011 to get a widget in 2012. Just as with the interest rate cut, widgets have become 1 percent cheaper today relative to the future.

This change in relative prices means that the increase in the consumption tax will stimulate consumption demand in 2011. Why, then, do we need a labor income tax reduction in 2012? The problem is that a consumption tax that begins in 2012 distorts labor supply decisions in a way that interest rate cuts don’t. Consider a worker who makes $20 an hour in 2012 after the various taxes on labor income. If the consumption tax goes up, that worker can buy fewer widgets with each hour of work. Hence, the consumption tax distorts that worker’s decision about how much labor to supply to the market.

That’s why we need the second part of the plan, under which the fiscal authorities lower taxes on labor income by one percentage point beginning in 2012. With this tax decrease, the worker makes 1 percent more per hour after taxes. The increase in after-tax wages exactly offsets the decrease in purchasing power generated by the consumption tax, and a worker can again buy 20 widgets with each hour of work. As a result, the new plan makes consumption goods cheaper in 2011, but does not provide any additional distortion to labor supply decisions.

At this point, I’ve talked through the first two parts of the proposal—the permanent increase in consumption taxes and the permanent decrease in labor income taxes. Why do we need a third tax change? Unlike an interest rate cut, the consumption tax that begins in 2012 will deter investment in 2011. The third prong of the proposal is that the fiscal authority should correct this problem by offering an appropriately sized temporary investment tax credit in 2011. The key is that the tax credit need only apply in 2011. In 2012 and thereafter, there is no disincentive effect on investment because the consumption tax is constant.

 To summarize, I have described how to construct a three-pronged fiscal policy that is designed to have the same economic effects as a 100-basis-point cut by the Fed. The 1 percent permanent consumption tax that begins in 2012 stimulates consumption demand in 2011. The permanent reduction in labor income taxes ensures that this new consumption tax does not deter labor supply. Finally, the investment tax credit makes sure that the new consumption tax does not deter investment in 2011.

I’ll make two additional comments about this plan. First, how much would this three-pronged change in taxes cost the American taxpayer? The exact answer to this question would depend on a host of details. But let me offer a very rough calculation. Annual consumption is about $10 trillion, and annual labor income is about $8 trillion. I’ve sketched a plan that involves increasing the tax rate on consumption by 1 percentage point and lowering labor income taxes by 1 percentage point. So, the first two parts of the plan would add about $20 billion per year to government revenue beginning in 2012.

The plan also involves an appropriately sized investment tax credit. Private gross investment is about $2 trillion. To offset the effect of the consumption tax in 2012, the fiscal authority needs to provide a 1 percent subsidy to this entire amount. Hence, the investment tax credit involves a one-time cost in 2012 of $20 billion. These calculations, while obviously very rough, do indicate that the plan has the potential to be fiscally responsible.⁴

Second, I’ve not discussed distributional considerations. Raising consumption taxes by 1 percentage point and lowering labor income taxes by 1 percentage point for all Americans would tend to redistribute the burden of taxes toward lower-income citizens. For this reason, I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.

I want to be clear that there may be other types of fiscal policy interventions that would be helpful in the current situation. I have deliberately focused on a rather narrow aspect of fiscal policy: How can it be used to mimic monetary policy? I’ve done so for a couple of reasons. First, I’m a monetary policymaker, not a fiscal policymaker. Second, as has become clear over the past three years, the efficacy of many kinds of fiscal policy interventions is still very much an open question among macroeconomists. There is considerably more professional consensus about the effectiveness of monetary policy. In the case of my three-pronged fiscal intervention, it is specifically designed to be effective, as long as monetary accommodation itself would be effective.

From an intellectual point of view, the analysis demonstrates the remarkable power of public finance in addressing important macroeconomic questions. This last lesson is hardly new. Over the past 30 years, macroeconomists have used the tools and methods of public finance to address a host of important questions, ranging from optimal stabilization policy to optimal unemployment insurance. I’m proud to say that a great deal of that work has been done at the Federal Reserve Bank of Minneapolis.

Thanks for your attention. I’ll be happy to take your questions.

I have had the pleasure of meeting with a number of business leaders from the Sioux Falls area prior to this event. I would like to thank you all for taking time from your busy schedules. Included in this group are current and former members of our bank’s board of directors and advisory councils for small business and agriculture, and I would especially like to thank them all for their service to the Federal Reserve and, by extension, to the nation as a whole. As I will discuss more in a moment, one of the great benefits of taking trips like this is to meet with local residents to gain a deeper understanding of what is happening in the local economy. And one of the pleasures of giving talks like this is taking your questions at the end. I always learn a great deal from these discussions, and so I look forward to hearing from you at the close of my remarks.

In this speech, I will discuss current macroeconomic conditions and the Federal Open Market Committee’s recent actions taken in response to those conditions. I’ll move on to dive a little deeper into conditions in the U.S. labor market. I’ll close by talking briefly about uncertainty and its drag on the economic recovery. The views I express here today are my own, and not necessarily those of my colleagues in the Federal Reserve System.

Let me start with some basic context about how monetary policy gets made in the United States. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. As I mentioned, our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. (Actually, in the September meeting, there were only four governors. The good news is that we were back up to six governors by the November meeting, and the White House has nominated Peter Diamond—who just won the Nobel Prize in economics—for the remaining vacancy.) However, the committee itself consists only of the governors, the president of the Federal Reserve Bank of New York, and a rotating group of four other presidents (currently Cleveland, St. Louis, Kansas City, and Boston). I’ll be on the committee in 2011.

In this way, the structure of the FOMC mirrors the federalist structure of our government. Representatives from different regions of the country—the various presidents—have input into FOMC deliberations. The input from the presidents relies critically on information they receive from their districts about local economic performance. We obtain this information through the work of our research staffs—but we also obtain it from business leaders in industries and towns, in my case, across the Upper Midwest. The Federal Reserve System is deliberately designed so that the residents of Main Street are able to have a voice in monetary policy.

With that backdrop, let me move on to discuss the FOMC’s most recent deliberations. The foundation of the committee’s discussions is what is called its dual mandate. By statute, the Federal Reserve is required to provide appropriate conditions for long-run economic performance by achieving both price stability and maximum employment. The former objective of price stability is generally understood as keeping inflation in a range of around 1.5 to 2.5 percent. The second part of the mandate—maximum employment—is more of a moving target, because employment is shaped by many determinants beyond the Fed’s control: demographics, social custom, taxes, technology, and so on.

Over the first three quarters of this year, personal consumption expenditure (PCE) price inflation has averaged roughly 1 percent at an annualized rate. This rate is low relative to the FOMC’s target of 2 percent. More troublingly, the inflation rate is drifting downward. Over the preceding two-year period (from the fourth quarter of 2007 through the fourth quarter of 2009), PCE inflation averaged 1.6 percent per year.

At the same time, unemployment is high: In October, it was 9.6 percent. Here, too, the trend is not comforting. The recession officially ended in June 2009, and in that month, unemployment was 9.5 percent. Unemployment has actually risen slightly during the course of the recovery.

Sufficient growth in output can steadily lower unemployment. But growth has been low in this recovery compared with most. As I mentioned, the recession officially ended in June 2009 and so has been over for five quarters. Over those five quarters, real gross domestic product (GDP) has grown at an annualized rate of under 3 percent. More alarmingly, growth has been decelerating: In the past two quarters, it has averaged less than 2 percent at an annualized rate.

This is the economic situation that confronted the FOMC in its November meeting. Inflation and employment are both too low, and the pace of recovery is too slow. Economic growth is low and softening further. I think it is safe to say that, given this situation, the FOMC would have liked to have been able to cut its target interest rate. But this option is not available. The FOMC’s target interest rate is already essentially at zero (more precisely, in a range between 0 and 25 basis points).

But the FOMC does have another policy instrument available: its balance sheet. As of the beginning of this month, the FOMC had a portfolio of roughly $2.3 trillion. Over 2 trillion of those dollars are invested in Treasury securities or government-backed securities issued by Fannie Mae, Freddie Mac, and other government-sponsored enterprises. At its November 3 meeting, the FOMC announced that it plans to buy $600 billion of long-term Treasuries in the open market by mid-2011. In exchange for those securities, it will credit the sellers’ accounts at the Fed with more reserves. This kind of action is known as quantitative easing, or QE.

The main goal of QE is to lower the long-run real interest rate. Just to be clear, by real interest rate, I’m referring to the interest rate net of expected inflation. More specifically, suppose that the interest rate on a 10-year bond is about 2.5 percent and that people expect inflation to be around 2 percent per year over the next 10 years. Then, the real interest rate is about 0.5 percent per year for the next 10 years.

A low long-term real interest rate stimulates an economy in a number of ways. It spurs consumer spending by allowing consumers to borrow and refinance more cheaply. It makes capital expenditures and hiring more profitable for corporations. Stock prices and house prices rise because those assets become relatively more attractive as investments. Households with these assets become wealthier and demand more consumption. All of these effects should lead to less unemployment and upward pressure on prices.

How does QE go about lowering long-term real interest rates? QE is a sufficiently novel monetary policy tool that different economists may well give different answers to this question. In my view, QE lowers long-term real interest rates in two distinct ways. The first is that QE is a form of nonverbal communication about the FOMC’s future plans. Here’s what I mean. The November FOMC statement says that the committee will keep the fed funds target range exceptionally low for as long as economic conditions warrant. The statement also predicts that exceptionally low fed funds rates are likely to be warranted for an “extended period” of time. In this way, the statement provides explicit communication about the FOMC’s future plans for short-term rates and so also shapes the level of current longer-term interest rates.

QE provides a significant supplement to this explicit verbal communication. The use of QE indicates that the FOMC is likely to keep its target interest rate lower for an even longer period of time. Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.

Thus, QE lowers long-term real interest rates by signaling the FOMC’s intentions about future short-term rates. However, QE also lowers long-term real interest rates in a second, more direct, way. The holder of a long-term Treasury is exposed to interest rate risk, because the value of that bond fluctuates as interest rates vary. When the Fed buys $600 billion of long-term bonds, the bond portfolio of the private sector is now less exposed to this kind of risk. As a consequence, private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, and all long-term yields fall.

In this way, the change to the asset side of the Fed’s balance sheet provides stimulus to the economy. But what about the liability side of its balance sheet? QE creates more reserves in banks’ accounts with the Fed. The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. More money chasing the same amount of goods—voila, inflation.

Given some of the criticisms of the Fed that have been voiced over the past three weeks, it is important to understand that this basic logic isn’t valid in current circumstances. Banks have nearly $1 trillion of excess reserves. This means that they are not using a lot of their existing licenses to create money. QE gives them $600 billion of new licenses to create money, but I do not see why they would suddenly start to use the new ones if they weren’t using the old ones.

Some observers have expressed concerns that $1 trillion—which will shortly become over $1.5 trillion—of excess reserves represent what they term “kindling” for some future inflationary fire. I believe that these concerns are misplaced for two reasons. First, the Fed has several tools with which to combat incipient inflationary pressures. Most obviously, it can raise the interest rate on excess reserves as a way of deterring banks from creating money with their licenses. Second, in recent public statements, Chairman Ben Bernanke has explicitly and firmly committed the FOMC to maintaining low inflation. To use his exact words, he said that he has “rejected any notion that we are going to try to raise inflation to a super-normal level.”

As I mentioned before, I do not currently vote on FOMC decisions. I did express support for the FOMC’s decision at the recent meeting. As I have said on prior occasions, I believe that there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. Nonetheless, the FOMC’s decision seemed to me to be a move in the right direction.

In the remainder of my prepared remarks, I’ll dig a little deeper into the behavior of the labor market. I’ll use that discussion as a springboard to talk about some longer-run uncertainties that I see as a drag on short-run and medium-term economic performance.

I’ll begin by reminding you of some terms that economists use to talk about labor markets. Every month, the Census Bureau interviews 60,000 households consisting of about 110,000 individuals. The bureau asks a host of questions, but there are two particularly important ones: Have you worked for pay or profit in the past week? If not, have you looked for work in the past four weeks? The former group is counted as the employed. The second group is counted as the unemployed. The sum of these groups is called the labor force. Anyone who answers no to both questions is regarded as being out of the labor force. Note that the Census Bureau pays no attention to whether the interviewee is collecting unemployment benefits or not.

With those definitions—employed, unemployed, and labor force—in mind, I’ll divide the unemployed further into two subgroups. Following the Bureau of Labor Statistics, I’ll refer to those people who have been unemployed for more than six months as being “long-term” unemployed. By way of contrast, I’ll use the term “short-term” unemployed to refer to those who have been unemployed for less than six months. I’ll do so while realizing that this latter terminology is more than a little misleading. Most of us would think of someone who has been out of work for six months as having been unemployed for a long, not short, period of time.

In December 2007, at the start of the recession, 4.1 percent of the labor force was short-term unemployed. The recession generated a marked increase in this number. It officially ended in the second quarter of 2009, and in June of that year, 6.7 percent of the labor force was short-term unemployed.

Over the next 14 months, the recovery generated a noticeable increase in job openings. The short-term employment rate responded by regaining nearly half of its recession losses. By the end of October 2010, 5.6 percent of the labor force was short-term unemployed. So, if you only looked at this limited measure of unemployment, you would say: Well, the economy certainly has a long way to go. But we have made progress—in some sense, we’re about halfway back. I should note, though, that this recovery in the six-months-and-under unemployment rate has definitely slowed since May.

The problem is that the long-term unemployment rate has not exhibited even this limited amount of progress. In December 2007, only around 0.9 percent of the labor force was long-term unemployed. By June 2009, that number had more than tripled: 2.8 percent of the labor force was long-term unemployed. By October 2010, 16 months into the recovery, that number had risen to 4 percent. This number is unprecedentedly high. As well, nearly three-fourths of the long-term unemployed had in fact been unemployed for over a year. Again, it is unprecedented in post-World War II U.S. history to have 3 percent of the labor force unemployed for over a year. If history is any guide, this year-plus unemployment rate will only revert to prerecession levels after several years.

The recession has also had a big impact on the employment-population ratio. In March 2007, 63.4 percent of those over 16 had a job. That number has fallen to 58.3 percent. Other than last December, the employment-population ratio had not been this low since mid-1983—27 years ago. To understand how much the employment-population ratio matters, I think it’s useful to think about it in a slightly different way. In March 2007, each working person supported 0.58 persons over the age of 16 in addition to themselves. In October 2010, each working person supports 0.72 persons over the age of 16 in addition to themselves. Essentially, every working person now has to support 24 percent extra people over the age of 16. This is a large increase in the burden that each worker faces. Will this fall in the employment-population ratio reverse itself over the next three or four years? I believe that the standard of living of many Americans depends on the answer to this question.

I’ve been emphasizing uncertainties in the labor market. More generally, I believe that overall uncertainty is a large drag on the economic recovery. One way to gauge the current level of uncertainty is to look at the level of the yields on Treasury inflation-protected securities—so-called TIPS bonds. A five-year TIPS bond has a yield of around –20 basis points. This means that people are giving up $100 today in exchange for about $99 of purchasing power in five years. Savers are willing to lose purchasing power over time rather than consume more today. Similarly, firms are willing to lose purchasing power over time rather than making more capital expenditures.

What explains this behavior on the part of firms and savers? The answer lies in uncertainty about the next five years. Some of it is intrinsic to the structure of the U.S. economy itself. I’ve discussed the importance of the employment-population ratio. Will the level of employment in 2015 look more like employment in 2000, 2007, or 2010? Will the level of housing prices in 2015 look more like housing prices in 2000, 2007, or 2010? My own assessment is that no policymaker or set of policymakers—no matter how gifted—has the tools available to resolve these uncertainties.

But part of the public’s uncertainty has to do with the nature of future taxes and government spending. The federal debt in the hands of the public has gone up by over 50 percent over the past three years. At the same time, the U.S. government has taken on responsibilities for the debts of Fannie Mae and Freddie Mac. It has enacted a new health care plan. Do these changes mean that taxes will rise? If so, taxes on what forms of economic activity? Does it mean that government will cut back on its provision of important types of public goods or on entitlement programs? If so, what kinds of public goods or entitlement programs? Investors and savers need a lot more clarity about what those answers might be. Absent such clarity, the economic recovery will be slower than it otherwise would be.

I don’t have the answers to these and other questions about long-run economic policy. However, I do feel from my travels around the Ninth District that the answers may lie within the Upper Midwest. It is certainly true that many parts of the district have found the recent recession to be a challenging time. Nonetheless, the district has generally fared better economically during the recent recession than the nation as a whole. Some of this relative success can be explained by strong markets for oil, minerals, and agricultural commodities. But it is also true that many cities in the Ninth District—like Sioux Falls—are mostly removed from these economic phenomena—and yet they continue to perform well.   We at the Minneapolis Fed are working hard at understanding the factors underlying the relative success of the District.   We very much hope that they prove to be ideas or approaches that can be replicated at the national level.

Thanks for your attention. I look forward to taking your questions.