Charles Evans, president of the Federal Reserve Bank of Chicago, suggested Monday that a rationale exists for the Federal Reserve to cut interest rates next week for the second time in two months, as most traders believe it will.
In his first speech on economic policy since becoming the Chicago Fed chief Sept. 1, Evans gave a fairly benign assessment of U.S. economic conditions but said one job of Fed policymakers is to take out insurance “against the highly adverse outcome,” even if the calamity is unlikely.
Evans is a voting member of the Fed’s monetary policy committee, which is scheduled to meet Oct. 30-31.
“Housing demand and [house] prices could weaken a good deal more than we expect, either because a new shock hits the sector or because we have underestimated the weakness already in train,” he told an economic forum at the University of Chicago Graduate School of Business.
Moreover, a greater-than-expected rash of mortgage delinquencies and foreclosures could deepen the wounds already being felt by financial markets trading securities tied to mortgages.
“Together, such events would pose a more serious downside risk to growth,” he said. “I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high-cost outcomes that we should guard against.”
The Fed staged a surprise one-half percentage-point cut in its benchmark interest rate Sept. 18, to 4.75 percent, after global credit markets nearly ran aground amid fears of unknown losses in risky debt portfolios. Evans said the Fed’s actions to loosen credit in August and September were “completely appropriate.”
“Markets are functioning better than they were two months ago,” he said, adding that economic data available at that time supported lower Fed interest rates, regardless of the financial market turmoil.
In response to a question, Evans said if house prices fall “quite dramatically” in the future, even people who are not seeking to sell their homes “might become more concerned and they wouldn’t go out and spend.” He said a reduction in the Fed’s interest rate target has a relatively rapid effect on making housing more attractive.
According to Evans’ analysis, a second rate cut as a pre-emptive move against unforeseen stress is more feasible given the current stable and “favorable” inflation outlook.
“We are finally operating in a world with two-side inflation risks,” he said. “We thought it was too high in early 2007 at 2.5 percent, but that it was too low in 2003 when, according to the data published at the time, it fell below 1 percent.”
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Inflation, as measured through data on personal spending in the economy not counting food and energy prices, should be just 1.5 percent to 2 percent in 2008 and 2009, Evans said. “Relative to our [higher] outlook six months ago, this a favorable development.”
In response to a question, Evans said he remains “sympathetic” to basing Fed inflation forecasts on the so-called core inflation rate, which excludes prices of food and energy. Some Fed officials and economists are talking about a greater need to take what appears to be a persistent increase in food and energy prices into account.
On Monday, the Chicago Federal Reserve Bank released its monthly national activity index, a compilation of 85 periodic economic indicators.
The three-month moving average of the index, used to smooth out monthly gyrations, was minus 0.31 in September, with the zero mark indicating normal economic growth. In August, the index registered a minus 0.20.
Both readings indicate subpar growth. In a research paper he co-wrote for the Chicago Fed before becoming its president, Evans found that readings less than a minus 0.70 were reached near the start of the six recessions from 1967 through 2001.
Monthly reports on existing- and new-home sales, scheduled to be released Wednesday and Thursday, respectively, are expected to show fresh declines in housing activity.
In his overall forecast, Evans said the nation’s economy will slow this fall, “but we see growth recovering next year” and returning to normal levels by later in 2008.
“Although we expect a small increase in the unemployment rate, labor markets generally should remain healthy,” he said.
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Bill Barnhart’s column appears Tuesday through Friday in the Business section. To read recent columns, go to chicagotribune.com/barnhart.