NEW YORK – Despite its promises, economic conditions may force the Fed to raise rates before the middle of next year, according to Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser.
“Monetary policy should be contingent on the economic environment and not on the calendar,” Plosser told participants at the 33rd Annual Economic Seminar in Rochester, N.Y., Wednesday, according to prepared text of his remarks, released by the Fed. “In my view, making a perceived commitment based on calendar time risks confusing the public about how policy is formed. If the Committee wishes to provide forward guidance, then a better way of conveying such information is necessary. My own view is that it would be better to provide more information about how policy responds to economic events, a sort of reaction function, than to make commitments based on the calendar that we may not keep.”
Noting he remains “optimistic about the economy’s future, Plosser said he believes “in the fundamental resiliency of our market economy.” While optimistic, Plosser said, “I’m also realistic. I know that in the past year, the U.S. economy has failed to live up to the expectations of growth that I and many economists had at the beginning of 2011.”
However, he issued a warning about inflation. CPI inflation last year was higher than expected – nearly 3.5% – as energy and food prices grew, but the core rose 2.2%. Plosser said he expects those numbers to moderate in the near-term.
“Looking further ahead, I believe we must monitor the inflation situation very carefully, particularly in this environment of very accommodative monetary policy,” Plosser said. “Inflation most often develops gradually, and if monetary policy waits too long to respond, it can be very costly to correct. Measures of slack such as the unemployment rate are often thought to prevent inflation from rising. But that did not turn out to be true in the 1970s. Thus, we need to proceed with caution as to the degree of monetary accommodation we supply to the economy.”
The economy failed to meet expectations because of shocks, including severe snowstorms, the earthquake and tsunami in Japan, and unrest in the Middle East and North Africa that led to a run-up in oil prices. Additionally, fiscal stress in Europe and Washington’s battles over fiscal policy and the debt ceiling “weighed heavily on growth, as well as on business and consumer confidence.”
Recession isn’t an issue, Plosser said, as growth should be near 3% this year and next.
But, he warned, “downside risks certainly remain.” Most notable ramifications of “the continuing sovereign debt crisis in Europe. An economic slowdown in the euro zone will likely restrain export growth in the U.S. And while strains in financial markets have been limited to European institutions so far, the situation bears watching to ensure that there are no adverse spillovers to U.S. financial institutions. Of course, regardless of how the European situation plays out, it has already imposed additional uncertainty on growth prospects for the global economy.”
Washington’s failure “to establish a clear plan to put our fiscal policy on a sustainable path” also pushes businesses and individuals “to postpone significant spending and hiring decisions -- posing a drag on the recovery, even as economic developments in the U.S. continue to improve.”
Another obstacle is household’s attention to their finances and reducing debt as declining home prices and stock market cut household wealth. “The natural response to such a decrease is for families to reduce consumption and increase saving, and that is exactly what we are seeing. Most economists believe that this process will take a while longer before consumers resume more normal spending and saving patterns.”
Businesses, he said, appear “further along in improving their balance sheets’ health and improving productivity.”
Plosser expects the housing market to stabilize, without “much improvement” this year. “We entered the Great Recession over-invested in residential real estate, and we are not likely to see a housing recovery until the surplus inventory of foreclosed and distressed properties declines,” he said. “As the economy rebalances, we may not see housing and related sectors return to those pre-recession highs, nor should we necessarily seek or expect them to do so.”
Also, labor woes continue “to be a major concern, with unemployment “uncomfortably high,” although recent employment reports were encouraging.
Turning to his dissent on recent FOMC monetary policy decisions, Plosser said, “Given the economic developments in August and September and the economic outlook, it was not clear to me that further monetary policy accommodation was appropriate. After all, inflation was higher and unemployment was lower relative to the previous year. Moreover, policy actions are never free; they need to be evaluated based on a thorough analysis of costs and benefits. I felt that the benefits of further monetary policy actions were small at best, since, in my view, they would do little to help resolve the challenges on the employment front.”
He said he feared more accommodation might mean a steady rise in inflation over the medium-term, in addition to not helping resolve the unemployment woes. “In my assessment, the potential costs outweighed the potential benefits of further accommodation.”
But, Plosser supports the efforts to improve transparency. “Improving the transparency of monetary policy has always been high on my list of things to do,” he said. “The Fed is accountable to the public, so it needs to be clear about its goals and approach to making policy decisions. Moreover, when households, firms, and markets have a better understanding of what to expect from monetary policy, they can make better financial plans and spending decisions. Thus, greater clarity helps monetary policy become more effective at promoting its congressionally mandated goals of price stability, maximum employment, and moderate long-term interest rates.”
Although the Fed now releases its Summary of Economic Projections, or SEP, quarterly, offering “information about the range of individual policymakers’ forecasts for key economic variables, including output, inflation, and unemployment,” they did not include monetary policy projections. “This lack of information makes it harder for the public to interpret the projections. For example, two FOMC participants might have considerably different growth forecasts. Is this because they have different views about the underlying dynamics of the economy? Or is it because they are assuming different policy paths?”
He explained, “Without any information about the assumed policy paths, it is harder to judge the meaning of differences or similarities of forecasts across FOMC participants.”
Hailing the Fed’s decision to release policy expectations, Plosser said, “giving the public a sense of Committee participants’ views on appropriate policy in the SEP conveys much more useful information about the likely future path of policy than using a calendar date, as we have been doing in our recent FOMC policy statements.”
Also, Plosser reminded, the “projections are not unconditional commitments of the Committee. The views of appropriate policy will evolve over time as economic and financial conditions change.”
To help clarify the Fed’s longer-run goals and monetary policy decision-making process, Plosser suggested three moves: defining an explicit numerical inflation objective; an explanation of why the FOMC cannot set a fixed long-run numerical objective for employment; and clarifying that the FOMC takes a balanced approach to setting policy.
Monetary policy determines the inflation rate, so the FOMC can set a “longer-run numerical goal for inflation and should be held accountable for achieving that goal,” Plosser said. But “maximum employment is largely determined by factors that are beyond the direct control of monetary policy. These factors include such things as demographics, technological innovation, the structure of the labor market, and various governmental policies – all of which will vary over time.”
Since estimates of maximum employment are subject to substantial uncertainty, “I do not believe the FOMC should set a fixed numerical objective for something that it does not directly control and cannot accurately measure.”
As for the third element, he said, “By balanced approach I mean one that promotes all of our congressionally mandated objectives of maximum employment, stable prices, and moderate long-term interest rates. In particular, the Committee’s policy judgments will seek to mitigate fluctuations in employment and inflation in the face of significant economic disturbances.”
