MNI POLICY: Fed's Evans Says Policy May Need to be Loosened

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve may need to cut interest rates if

inflation and inflation expectations continue to run too low, Chicago Fed

President Charles Evans said Friday, adding that he is "uneasy" about the

outlook for inflation after a recent drop in core price measures.

     Some of the drop in core PCE inflation since December may be due to

temporary special factors, but "we don't want to be too dismissive of this

development," he said. Underlying inflation trends may be "mired below 2%" and

inflation expectations remain lower than in the recent past.

     "If activity softens more than expected or if inflation and inflation

expectations continue to run too low, then policy may have to be left on hold --

or perhaps even loosened -- to provide the appropriate accommodation to obtain

our objectives," he said in a speech prepared for the National Association for

Business Economics and Sveriges Riksbank Conference in Stockholm.

     Evans has long expressed concern over the risk to the Fed's credibility due

to its inability to declare victory on its inflation mandate.

     The Fed "must be willing to embrace inflation modestly above 2% as often as

50% of the time" to bolster its credibility, he said. "Indeed, I would

communicate mild comfort with core inflation rates of 2.5%, as long as there is

no obvious upward momentum and the path back toward 2% can be well managed."

     Below are other major points from his speech:

     --So-called "insurance" rate cuts of 75 basis points over two months in

1998 helped the economy weather a deterioration in domestic financial conditions

from the Russian default. Productivity accelerated sharply afterwards and by

early 1999 growth was firm enough to allow the FOMC to raise rates by 175 basis

points by May 2000.

     --Alternative inflation targeting frameworks under consideration, including

price-level targeting and inflation averaging, can deliver very good

macroeconomic outcomes when rates are close to zero, but their success relies on

the public's believing the Fed can deliver periods of above-target inflation

following episodes of undershooting.

     --There are benefits and costs involved with moving to a shorter duration

securities portfolio. It would generate somewhat more restrictive financial

conditions and headwinds for the economy, meaning the equilibrium fed funds rate

"would have to be lower to offset the higher long-term interest rates." That

gives less policy room to cut rates in the event of a downturn. On the other

hand, holding more bills would allow the Fed to repeat Operation Twist to

provide additional accommodation without expanding the balance sheet. More

analysis is needed to decide portfolio duration.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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