Chicago Federal Reserve Bank President Charles Evans said on Monday that outside of housing the U.S. economy is "moving forward," and that the Fed cannot afford to go soft on inflation.
"We cannot afford to be lax on the inflation front," Evans said in a speech to a University of Chicago Graduate School of Business global markets forum. "I would see any increase in inflation or inflation expectations from their current levels as a serious concern."
Evans said U.S. economic activity will remain "soft" this fall, still dragged down by the decline in residential housing investment. "But we see growth recovering next year and moving up to average close to potential later in 2008," Evans said, terming potential growth "somewhat above 2.5 percent."
The Federal Open Market Committee lowered its key lending rate by one-half percentage point on Sept. 18, its first rate cut since 2003, after weeks of turmoil in credit markets triggered by problems in the U.S. subprime mortgage sector.
That preemptive policy action has helped guard against a worst-case outcome for the economy after August's financial market shakeout, Evans said.
"At times we may need to adopt a risk management approach to policy -- that is, adjust the stance of policy to guard against the risk of events that ... if they did occur, would present an especially notable threat to sustainable growth or price stability," he said.
Still, risks remain that housing demand and prices "could weaken a good deal more than we expect," pulling consumer spending down as well, despite recent evidence of resiliency in consumer spending.
Further delinquencies and foreclosures could add to the problems with mortgage-backed securities and "pose a more serious downside risk to growth," Evans said. "I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high-cost outcomes that we should guard against," he said. "If in fact the more likely scenario unfolds, in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook."
Evans was making his first public remarks on the economy since taking over at the Chicago Fed from Michael Moskow in September. He is a voting member of the Federal Open Market Committee in 2007.
A former director of research at the Chicago Fed, Evans termed the most recent inflation numbers "positive" and the balance of the economic data since the September FOMC meeting as supportive of the Fed's baseline forecasts.
The core personal consumption expenditures (PCE) price index should be in a range of 1.5 percent to 2 percent in 2008 and 2009, Evans said. "Relative to our outlook six months ago, this is a favorable development," he said.
Evans said the recent changes to inflation and productivity have lowered the effective neutral rate on federal funds. Coming into the September FOMC meeting "it was no longer appropriate for monetary policy to include a slight degree of policy restraint," he said.
He added that U.S. interest rate policy was moderately restrictive before September's policy meeting.
The Fed's policy actions to date, notably its 50 basis point cut to the federal funds rate last month, have been "entirely appropriate," Evans said. The world economy is "doing about as well as I've seen," providing a buffer against slower growth in the United States.
The Fed cannot target policy to a specific sector, such as the mortgage industry, Evans said when asked about the large number of job cuts expected in that sector.
Evans said recent jobs growth of about 100,000 per month in August and September is consistent with "an economy growing at potential." Labor markets in general should remain healthy, although the jobless rate is likely to increase slightly from its current level, he said.