NEW YORK – Monetary policy should be focused mostly on inflation, and to a lesser degree on output growth, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said today.
“Thus, even in the wake of the financial crisis, I continue to advocate that the Fed follow a systematic approach that keeps monetary policy focused squarely on inflation and output growth, but especially on inflation,” Plosser told the Cato Institute, according to prepared text of his speech, which was released by the Fed. “To the extent that booms may engender excess leverage in systemically sensitive parts of our financial system, we need to ensure that regulations and institutional structures are designed to enhance market discipline in ways that keep risk-taking under control. Monetary policy should retain its focus on providing price stability as a means to support sustainable growth in employment and output over the long run and not chasing incipient bubbles.”
He cautioned that he does not favor raising interest rates just “to lower asset prices when they appear to deviate from fundamentals. This is a policy that is easy to get wrong and fraught with risks.”
Also, such a policy could cause the Fed to make moves “that would draw it ever deeper into credit allocations and the determination of relative prices,” Plosser said. “That should not be the role of monetary policy.”
In the mid-2000s, Plosser said, Fed policy “went off track.” In fact, he said, during that period he argued “fears of deflation were excessive and that policy was probably too accommodative. The error may not have been that policymakers failed to pay attention to the fast upward rise in asset prices, but that they deviated from a systematic approach to setting nominal interests.”
Plosser advocates systematically varying the target interest rate in line with movements in an estimate of the real interest rate. “In the face of economic shocks that result in an increase in the real interest rate, the central bank should respond by raising its target rate commensurately, as long as inflation is at or near its target,” he said. “Failing to do so will lead to higher inflation in the future. Similarly, if shocks cause a decrease in the equilibrium real interest rate, then the central bank should lower its target interest rate to avoid disinflation.”
In this scenario, he said, “policy actions provide a natural response to broad-based increases in real rates of interest that often accompany asset-price inflation.”
Problems with this approach include: real interest rates are estimated “based on observations of inflation and proxies for expected inflation. Moreover, trying to infer movements in the real interest rate from changes in prices for a wide range of assets, some of which may be moving in opposite directions, is quite a challenge.”
Basing monetary policy on output or unemployment gaps or basing policy on asset-price gaps – or bubbles – would require policymakers to “distinguish between departures from efficiency and an efficient response to an unobserved, yet fundamental shock,” which Plosser said is quite difficult. “I doubt we could find enough agreement among policymakers or economists about the interpretation of asset-price movements to allow for stable, rule-based policymaking.”
Since asset prices are often volatile, having monetary policy “influence the price-setting mechanism seems more dangerous for the orderly functioning of markets than helpful even in the rare instances when a true and significant distortion may in fact exist,” Plosser said.
Besides, different assets have different characteristics, and by trying to assist one, the Fed would be damaging another asset.
“Thus, while I understand the desire to use monetary policy to reduce or eliminate misalignment of asset prices, I believe that implementing such a policy as a practical matter would not help us deliver better performance in terms of price stability and sustainable output growth,” he said.
