NEW YORK – The Federal Reserve cannot stop or immediately offset macroeconomic shocks, which threaten economic stability, and the public needs to realize that “there are limits to what central banking can do,” Federal Reserve Bank of Philadelphia President Charles I. Plosser said today.
While some have called for the Fed to assume expanded responsibilities as a result of the crisis facing the country, Plosser said, there must be a realization of the Fed’s limits.
“The Fed needs to be accountable for meeting its goals. Yet, we must take care to set reasonable expectations for what a central bank can achieve,” Plosser said in a speech to the Council on Foreign Relations in New York, according to text of the remarks, which were released by the Fed. “We must recognize that over-promising can erode the credibility of a central bank’s commitment to meet any of its goals, whether for monetary policy or financial stability.”
Some believe “if the Fed were simply quicker or smarter or given more regulatory powers by Congress, we could always counteract the adverse effects of these shocks and easily achieve monetary policy’s dual mandate to keep the economy growing with full employment and little or no inflation,” Plosser said. But this does not distinguish “between what the Fed can do in the long run and what it might be able to do in the short run” and “it assumes the Fed has the ability to stabilize the economy against the adverse effects of almost all macroeconomic shocks. On both counts, this view seriously overstates the true capability of the Fed or any central bank in modern market economies.”
Inflation is all that sound monetary policy can control long-term. Also “all sorts of shocks are simultaneously buffeting the economy. Shocks can occur to specific sectors or specific regions. Some may be large and some may be small. Some may be positive and boost economic growth, while others may be detrimental to growth. If monetary policy responded to one shock in an attempt to offset its possible effects, it may aggravate the effects of another shock.”
So monetary policy cannot neutralize the impact of shocks. He said the best way to guard against shocks is “predicting the state of the economy more than a year from now with a high degree of accuracy — including anticipating the nature, timing, and likely impact of future shocks,” which is nearly impossible.
“Going forward,” he said, “just as we should avoid setting unrealistic expectations for monetary policy, we should also avoid encouraging unrealistic expectations about what the Fed can do to combat financial instability. As I have argued, in times of financial crisis, a central bank should act as the lender of last resort by lending freely at a penalty rate against good collateral. Yet, recent experience suggests we need to clarify what the Fed can and cannot be expected to do in today’s complex financial environment.”
Plosser called for regulatory reforms to lower the chances of financial crisis, and said “We should consider market structures, clearing mechanisms, and resolution procedures that will reduce the systemic fallout from failures of financial firms. Indeed, it would be desirable to be in an environment where no firm was too big, or too interconnected, to fail.
“Yet regulatory reforms must recognize that modern financial systems will never be immune to financial problems. Encouraging the belief that any system of financial regulation and supervision can prevent all types of financial instability would be a mistake. Instead, our goal should be to lower the probability of a financial crisis and the costs imposed from any troubled financial institution.”
