NEW YORK – The Federal Reserve’s accommodative policy “may soon backfire” unless steps are taken to remove accommodation, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said Tuesday.
“If the economy begins to grow more quickly and the sustainability of this recovery continues to gain traction, then the [$600 billion Treasury] purchase program will need to be reconsidered along with other aspects of our very accommodative policy stance,” Plosser told the Philadelphia Chapter of the Risk Management Association, according to prepared text released by the Fed. “We are a year and a half into a recovery, although a modest one. The aggressiveness of our accommodative policy may soon backfire on us if we don’t begin to gradually reverse course. On the other hand, if serious risks of deflation or deflationary expectations emerge, then we would need to take that into account as we adjust our policy stance.”
Economic growth did not meet expectations in 2010, Plosser said, explaining that he predicted GDP growth of 3% to 3.5%, but now it appears that when the numbers are released later this month, they’ll be between 2.5% and 3%, which he expects to grow to 3% to 3.5% in 2011 and 2012.
“I remain confident that the economy is on track for continued moderate recovery,” he said, adding there are risks that could alter the forecast. “But for now, I expect moderate growth overall, with strength in some sectors more than offsetting weakness in others.”
Of course, he pointed to housing as an area that will stay weak this year, but Plosser said he doesn’t expect real estate weakness to impinge on “recovery of the broader economy.”
Turning to the bright spots in the economy, Plosser noted businesses have increased spending on plant and equipment and appears to be strengthening.
Using his bank’s monthly Business Outlook Survey of regional manufacturers as proof, Plosser noted, the survey “has been consistent with an improving economy, showing significant gains in general activity, orders, and shipments in November and December, following some weakness during the summer months.” Additionally, optimism is seen in its expectations for future activity.
Consumer spending has picked up moderately, he said, and it will grow “as households recover more of the net worth destroyed due to falling house prices and the decline in equity portfolios during the recession. Households have been steadily shoring up their balance sheets, and as debt levels fall and savings are rebuilt, consumers will be in a better position to increase spending.”
While the private sector increased by more than a million jobs in 2010, Plosser said, “pace of employment growth hasn’t been strong enough to have much of an effect on the unemployment rate. However, recent data have been somewhat more encouraging.” Initial jobless claims as well as continuing claims have been declining, while non-farm payrolls have risen and the unemployment rate has fallen.
While he expects the unemployment to “bounce around in the near term,” it will eventually revover.
“I wish I could forecast a faster improvement,” Plosser lamented, “but it will take time to resolve the difficult adjustments now under way in the labor markets. Many workers may be forced to find jobs in new and unfamiliar industries.”
Inflation should remain subdued and there is no significant risk of sustained deflation, Plosser said. “Brief periods of lower-than-desired inflation or even temporary deflation are unlikely to materially affect economic outcomes as long as longer-term inflation expectations remain well anchored and the public continues to see the Fed’s promise to maintain price stability as credible.”
But since rates are near zero, the The Fed’s challenges rise because “a loss of credibility resulting in a decline in inflation expectations would lead to an increase in the real interest rate, which would encourage consumers and businesses to save more and spend less,” he said.
“Given that the Fed’s policy rate is now close to zero, a decline in inflation expectations would be unwelcome and could undermine the recovery. Fortunately, this is not happening. Expectations of medium- to long-term inflation have remained relatively stable because people expect the Fed to take appropriate action to keep inflation low, positive, and stable.”
Turning to monetary policy, Plosser sai he favors policymakers expressing differing opinions. “First, the uncertainty is real. It would be disingenuous and misleading to suggest otherwise. The central bank owes the public clear communication and as much transparency as is feasible. For policymakers to project a false sense of certainty would fail that test and deeply trouble me.
“Second, for monetary policy to be successful, policymakers, and the Fed as an institution, must earn the public’s confidence. Confidence is important in preserving the Fed’s credibility, which is something that is hard to earn but easy to lose. One way to undermine confidence and credibility is to fail to communicate the difficult choices we face and the thoroughness of our debates. Unanimity is not the natural state of affairs in life – nor is it inside the halls of the Federal Reserve. For policymakers to feign unanimity only serves to undermine the institution’s transparency.”
Turning to the FOMC decision to purchase an additional $600 billion of longer-term Treasury securities through the end of the second quarter of 2011, Plosser said, “It is no secret that I have expressed doubts about whether the benefits of this policy, commonly referred to as QE2, exceed the costs. These doubts were based on my reading of the economic outlook and the nature of the challenges that the economy faced.”
While it is true the first purchase program lowered interest rates, although there is some disagreement of by how much, the program worked because “financial markets were highly disrupted and asset risk premiums were extremely elevated,” Plosser said. “But markets are no longer disrupted. Thus, it seems unlikely that we can expect the effects to operate through the same channels as before. Even if we did, it is not clear to me that a modest reduction in long-term interest rates will do much to speed up the reduction in the unemployment rate.”
He continued, “Some commentators thought that even if the benefits were limited, the costs were small and the action was worth taking, given the concerns that many had about the state of the economy. Other commentators argued for the policy because the fiscal authorities were unable to act, even though fiscal policy would have been the more appropriate policy tool to address some of the challenges we faced. I view both of these arguments as flawed.
“It is a serious mistake to view monetary policy as a substitute for fiscal policy. ... To suggest that monetary policymakers must act simply because fiscal policymakers were unable or unwilling to act is not the proper way to conduct policy.”
Plosser said the Fed is “developing and testing tools to help us prevent such a rapid explosion in money to address this looming challenge. But we won’t know the full effect of these new tools until we use them. Nor will we know how rapidly or how high we may need to raise rates. The larger our balance sheet, the greater our challenges to successfully navigate an exit strategy without disrupting the economy and while keeping inflation under control.”
