Second, when interest rates are at the zero lower bound, the risks of tightening a bit too early are likely to be considerably greater than the risks of tightening a bit too late. A premature tightening might lead to financial conditions that are too restrictive, resulting in a weaker economy and, in turn, an aborted lift-off. This would be problematic in that it would harm the Fed’s credibility and, more importantly, would be difficult to rectify. The U.S. experience during the Great Depression and the Japanese experience over the past two decades illustrate the risks of raising interest rates too soon, especially when inflation is running below the central bank’s objective. Finally, given the still high level of long-term unemployment and the outlook for inflation, there could be a significant benefit to allowing the economy to run “slightly hot” for a while in order to get those that have been unemployed for a long time working again. I believe this can be done without jeopardizing our price stability objective. If the long-term unemployed are not employed relatively soon, their job skills will erode further, reducing their long-term prospects for employment and, therefore, the productive capacity of the U.S. economy. This would be a very unfortunate outcome for them, their families and the country. Market expectations that lift-off will occur around mid-2015 seem reasonable to me.
This implies a gradual reduction in the effect on actual M3 growth arising from the downward impact of the steep yield curve and the associated allocation of funds into longer-term deposits and securities outside M3. At the same time, the annual growth rate of M1 has continued to moderate, although it remained strong at 9.2% in June 2010. In part, this reflects somewhat higher opportunity costs of holding overnight deposits relative to other short-term deposits. The still weak annual growth rate of bank loans to the private sector continues to conceal countervailing developments, with increasingly positive growth in loans to households and stabilised negative annual growth in loans to non-financial corporations. A lagged response of loans to non-financial corporations to developments in economic activity is a normal feature of the business cycle. The data up to June indicate that, after expanding for a few months earlier in the year, the size of banks’ overall balance sheets has not increased further. The challenge remains for banks to expand the availability of credit to the non-financial sector when demand picks up. Where necessary, to address this challenge, banks should retain earnings, turn to the market to strengthen further their capital bases or take full advantage of government support measures for recapitalisation. In this respect, we welcome the EU-wide stress-testing exercise, which was prepared and conducted by the Committee of European Banking Supervisors (CEBS) and national supervisory authorities, in close cooperation with the ECB.