NEW YORK – While terming the recovery as “relatively slow but sustainable,” Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said that should there be proof that the latest round of quantitative easing is not working, he would back a change in policy.
While he remains “somewhat skeptical that we will see much of a stimulative effect from the new round of purchases,” Plosser noted the estimates for the first asset-purchase plan’s interest-rate relief varied.
“Yet, these purchases were done at a time when financial markets were highly disrupted and asset risk premiums were extremely elevated,” Plosser told a seminar in Rochester, N.Y., according to text released by the Fed. “But markets are no longer disrupted, so we cannot expect the same effect this time. Even if we did, it is not clear to me that a further reduction in long-term interest rates will do much to speed up the reduction in the unemployment rate to more acceptable levels. Indeed, if asset purchases don’t do much to accelerate aggregate demand, then the argument that the program will reduce the risks of deflation is also substantially weakened. The asset purchase program may help anchor expectations of inflation and ensure that they don’t fall. However, one might ask why adding $600 billion of additional excess reserves would help anchor expectations of inflation any more so than the $1 trillion currently in the system.”
While the program’s benefits may be modest, Plosser said, expanding the Fed’s balance sheet “will complicate our exit strategy from a very accommodative monetary policy, when that time comes.”
Plosser said Treasury “could achieve this same portfolio balance effect, in principle, without the Fed’s involvement, if it chose to issue fewer long-term bonds and more short-term securities.” He added interest rate risk would be the same either way.
Projecting 2.5% growth this year, down from year-ago predictions of 3.0%, and an average of 3.0% to 3.5% a year through 2012, Plosser said the better economy will provide optimism, leading to hiring pushing unemployment down gradually.
“As we move forward, I will continue to monitor incoming economic developments, update my economic outlook as necessary, and assess whether the stance of monetary policy is well positioned to deliver on our goals,” Plosser said. “Should evidence suggest that the new round of asset purchases is not delivering its intended benefits, and that policy must be adjusted to foster our long-run goals, I will support an appropriate adjustment in our policy stance.”
Private demand will be the key to economic growth, since neither businesses or consumers seem prepared to rapidly ramp up spending. Housing will stay weak “for a while longer,” with growth “after the economy is well into a healthy expansion.”
However, Plosser said, businesses are spending on plants and equipment. Credit terms are easing and interest rates at historic lows. “So I expect business to continue to make these fixed investments at a healthy pace over the coming year,” he said.
Until the labor markets improve, Plosser said, consumer spending will remain weak. This sector makes up about 70% of economic activity in the U.S.
Turning to inflation, Plosser noted, “headline CPI inflation has been near 1% this year. Even if we omit the prices of energy and food, which tend to be volatile, core CPI inflation has been just under 1% this year, down from 1.75% last year. These low inflation rates have led some observers to voice concerns that we may be entering a period of prolonged decline in the level of prices, or sustained deflation.
“While I do expect that inflation will be subdued in the near term, I do not see a significant risk of a sustained deflation,” Plosser said.
“Moreover, brief periods of lower-than-desired inflation or even temporary deflation are unlikely to materially affect economic outcomes, unless they destabilize inflation expectations in a period when monetary policy could not respond, because rates were already near zero,” he said. “In that case, real interest rates would rise, which would encourage consumers and businesses to save more and spend less. Given that the Fed’s policy rate is now close to zero, a decline in inflation expectations would 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. As the recovery continues, I anticipate that inflation will return toward 2% over the course of the next year.”
