Fed's Evans, Rosengren Reiterate Calls for Further Stimulus

On Monday, the Federal Reserve Bank of Chicago President Charles Evans reiterated his calls for further monetary stimulus, citing concerns over the health of the U.S. labor market and the overall economy. Speaking in Bangkok, Thailand, Evans said that the Fed should act more forcefully to counter high unemployment.

“Failure to act aggressively now will lower the capacity of the economy for many years to come,” Evans said. “I support using our balance sheet to provide additional accommodation.”

These calls for further balance sheet expansion - commonly known as quantitative easing or QE - follow the Fed's decision in June not to launch a new round of QE and instead extend the existing Operation Twist program.

Operation Twist is known as a balance-sheet neutral policy, in that the Fed does not increase the size of its balance sheet nor the money supply in these operations. QE on the other hand is not balance-sheet neutral. In QE, the Fed prints new money - liabilities on its balance sheet - and offsets this with purchases of bonds. Operation Twist is directly aimed at lowering borrowing costs as it is not necessarily stimulus (in the sense that it is not expansionary policy and is balance-sheet neutral), whereas QE is stimulus aimed at boosting growth and preventing deflation.

Speaking at the same conference, President of the Federal Reserve Bank of Boston Eric Rosengren highlighted similar fears. Rosengren said employment growth has “slowed fairly noticeably,” citing “significant excess capacity.” Rosengren noted that further QE would arrive if conditions continue to deteriorate.

“If we are missing our employment mandate by a large mark, but are close to our inflation target, then we should be willing to undertake policies that could substantially reduce the employment gap even if they run the risk of a modest, transitory rise in inflation that remains within a reasonable tolerance range,” said Evans.

Economists including Princeton's Paul Krugman have advocated higher-than-trend inflation as a solution to deleveraging witnessed in the economy. Evans seems to agree with this school of thought when he says that a transitory rise in inflation within a tolerable range would be acceptable. Banks, households, and even the public sector have been deleveraging for the last few years, which puts deflationary pressures on the economy. Higher inflation could help to negate these effects and boost nominal growth.

One of the best indicators for the Fed embarking on stimulus has been the 10-year breakeven yield. The breakeven yield tracks the difference in nominal and inflation-indexed yields of the same maturity and is thus indicates market expectation of inflation over the medium term. The Fed has only launched new easing policies when this yield has reached 1.75 percent or lower since 2008. The breakeven yield was 2.07 percent in early New York trading.

Rosengren's calls for a wait-and-see attitude from the Fed can be reflected in rates such as these. The fall of the 10-year breakeven yield from 2.44 percent in April shows that inflation expectations have waned as have global growth prospects. However, economists at the Fed may see this as not a large enough fall of inflation expectations to launch QE3.

Both Evans and Rosengren join the FOMC next year, the Fed's policy-setting committee.