NEW YORK – If the economy continues to strengthen, the Fed’s plan to buy $600 billion of longer-term Treasury securities may be ended early, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said Wednesday.
“Should economic prospects continue to strengthen, I would not rule out changing the policy stance to bring QE2 to an early close,” Plosser told the Rotary Club of Birmingham, Ala., according to prepared text of his speech, which was released by the Fed. “Thus, I will continue to look at the data and consider revising my forecast and preferred policy path as we gain more information on economic developments in the coming months. If the growth rates of employment and output begin to accelerate or if inflation or inflation expectations begin to rise, then it may be time to begin taking our foot off the accelerator.”
Plosser said he “expressed some doubts that the benefits outweigh the costs of this policy,” but backed it at the last FOMC meeting “because it is generally a good practice for a central bank to do what it says it is going to do unless circumstances significantly change. To do otherwise would undermine the institution’s credibility.”
Also, he noted, “I think monetary policy faces some difficult choices in the not-too-distant future. In particular, there is no question that, at some point, we will need to begin to remove the extraordinary amount of accommodation we have provided.”
Removing accommodation can be “tricky,” he said, especially this time because it involves raising rates and cutting the Fed’s balance sheet. Plosser said the Fed has the tools to do this, but it must be done “at the right time and at the right pace.”
Because “monetary policy operates with a lag,” accommodation must be removed “before unemployment has returned to acceptable levels,” he said, noting the Fed must show “the fortitude to exit as aggressively as needed to prevent a spike in inflation and its undesirable consequences down the road.”
The recovery is moderate but sustainable, so thought and difficult choices are ahead for policymakers to meet the Federal Reserve’s dual mandate, Plosser said.
“The Federal Reserve remains committed to its long-run statutory goals of promoting price stability and maximum employment,” he added. “Yet, I believe that finding the right path to attaining these goals, given where we have been, will require thoughtful deliberation and some difficult choices. Healthy debate is vital to that process and adds to the transparency and credibility of Federal Reserve policy as we move forward.”
Despite the improvement in the economy, Plosser said, “these are exceptionally challenging times for our economy.” Unemployment remains “stubbornly high,” the recovery, while uneven, has been slow, and housing is still weak at best, although it appears to be stabilizing.
Plosser said he expects GDP growth of about 3.5% a year in 2011 and 2012, and while any forecast carries risks, “I believe the improvement in household and business balance sheets and better labor market conditions will support moderate growth overall, with strength in some sectors more than offsetting weaknesses in others.”
Businesses are spending on plants and equipment, rebuilding inventory, and loosening the purse strings on capital spending that had been delayed by the recession. With manufacturing activity improving should keep business spending at a healthy level.
Additionally, consumer spending, a huge part of GDP in the U.S., has also accelerated, as “households continue to pay down debt and are rebuilding some of the net worth that was destroyed during the recession due to falling house and stock values,” Plosser added. “As household net worth improves, consumer spending should support growth going forward.”
One problem with consumer spending is that it will not be sufficient to propel the economy without job growth, he said. “The good news is that there are signs that labor market conditions are improving.” He estimated unemployment will gradually fall to 8.5% by year end “and somewhere between 7 and 8 percent by the end of 2012.”
Although Plosser’s forecast is rosier than some, “it still represents only a gradual pace of improvement given the depth of the recession. Unfortunately, I believe this is the most likely outcome because there are still significant adjustments that must occur in the labor market,” including retraining.
While inflation remains low, Plosser noted, he never believed there was a significant risk of a sustained deflation. He sees inflation growing “toward 2% over the course of the next year.”
Plosser said, “My sense is that as the recovery continues to pick up steam and firms become more convinced that demand increases will be sustained, they will feel more confident that they can put through price increases and have them stick.”
Recently, the Federal Open Market Committee was forced to react to economic and financial challenges, but Plosser said, “Now, we must step back from our focus on significant short-term fluctuations and crisis management and think more broadly about what monetary policy can and should do going forward.”
