Fed's Evans says U.S. economy to pick up in 2008

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.

Evans endorsed the Fed's recent interest rate cut, which he said provided "insurance" against worst-case fallout from turbulent credit markets, but said policy-makers may need to "recalibrate" if a feared extreme event does not occur.

"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.

Evans said U.S. economic activity will remain "soft" this fall, still hurt by the steep 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."

In contrast to the sluggish U.S. economy, the world economy "is doing as well as I've seen" in 16 years of observation, Evans said during a question and answer session following his speech.

The Federal Open Market Committee lowered its key lending rate by one-half percentage point on September 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 move 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 mortgage delinquencies and foreclosures could add to the problems with mortgage-backed securities and "pose a more serious downside risk to growth," Evans said.

"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 made his first public remarks on the economy since taking over at the Chicago Fed from Michael Moskow on Sept 1. He is a voting member of the Federal Open Market Committee in 2007.

Financial markets see a strong chance that the FOMC will lower rates again, by one-quarter percentage point to 4.5 percent, at the October 30-31 policy meeting.

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 he looks at many readings on inflation but is "more sympathetic" of core measures, or those stripped of volatile food and energy prices. Inflation is "ultimately a product of monetary policy," he said.

Evans said the recent changes to inflation and productivity have lowered the effective neutral rate on federal funds, "which meant that the stance of policy had become more restrictive."

There was arguably a case for a rate cut from the 5.25 percent that had prevailed for two years prior to last month's cut, even without the turmoil that engulfed credit markets in August, he said.

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.