More Faux Hawkishness: Plosser Says Fed Needs To Begin Reversing Accommodative Policy In Not Too Distant Future

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The key paragraph from the just released speech being delivered by Fed faux hawk Charles Plosser at the 20th Annual Hyman Minsky conference is the following: "It is no secret that I have long advocated that the Fed make explicit
its commitment to a numerical inflation objective.
It is consistent with
the view of central bankers and monetary economists around the world
and widely viewed as a best practice of central banking.... These advantages persuade me that the Fed should adopt an explicit
numerical inflation objective. Moreover, in my view, now is an opportune
time to do so. The apparent strengthening of the U.S. economy suggests
that, in the not-too-distant future, monetary policy will have to begin
reversing course from a very accommodative policy stance.
As we
choreograph that exit, I believe that the Fed should do all it can to
underscore its commitment to maintaining price stability." Key word here being "apparent" as yet another economist confused cause (loose monetary policy impact on the Russell 2000) and effect (equating the stock market with the economy). Perhaps the Fed economists should observe the dramatic paring of economic outlooks by all sellside analysts, in line with our expectations from January 2011. Take away the trillions in free money and everyone knows, but nobody wants to say, what will happen. We, for one, can not wait to listen to Fed president speeches following a 20% drop in the stock market...

Strengthening Our Monetary Policy Framework (link)

Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
20th Annual Hyman P. Minsky Conference, April 14, 2011, New York, New York

I appreciate the invitation to participate in the 20th annual Hyman
P. Minsky Conference on the State of the U.S. and World Economies. The
purpose of this year’s conference is to discuss the effects of the
global financial crisis on the real economy and to examine some of the
proposed policy responses that might prevent or mitigate the effects of
such crises in the future. In that spirit, today I would like to
recommend a way to strengthen our monetary policy framework. In
particular, I want to propose that the Federal Reserve adopt an explicit
numerical objective for inflation.

For the past three years, policymakers have been focused on
near-term efforts to stabilize financial markets and the real economy in
the face of the worst financial and economic crisis since the Great
Depression. Today, there is ample evidence that our economy is on the
mend and that a moderate but sustainable recovery is underway.

As the economic outlook improves, we have not only the opportunity
but the duty to begin focusing on the longer run and to consider
important monetary policy reforms that will lower the chances of
experiencing such a severe crisis again. I believe adopting an explicit
numerical inflation objective will enhance the ability of monetary
policy to achieve the Federal Reserve’s statutory mandates of price
stability, moderate long-term interest rates, and maximum employment. As
always, my remarks reflect my own views and do not necessarily
represent the views of the Federal Reserve Board or my colleagues on the
Federal Open Market Committee.

Recent events on the inflation front, I believe, are a useful place
to start. In the last few months we have witnessed sharp increases in
the prices of energy, food, and other commodities, and some are
concerned that this will result in higher than desired overall price
inflation. This is a remarkable turn of events. Less than a year ago the
prevailing concern was not that inflation was becoming too high but
that it was becoming too low. Indeed, some feared that the U.S. economy
was on the verge of a deflationary spiral. I was not one of them; nor do
I believe that we are in imminent danger of a strong acceleration in
inflation. Yet the swing in views does concern me. It suggests that the
public’s confidence in the Federal Reserve’s commitment to maintain
price stability is not as firmly established as I would like. This is
problematic for monetary policymakers, since this confidence is
essential for a central bank’s ability to actually deliver on the goal
of price stability for the economy.

One need only remember the period of the Great Inflation, from the
late 1960s to the early 1980s, to understand the importance of
credibility, commitment, and expectations for economic performance. The
Great Inflation occurred after a decade of very low and stable
inflation, a period that seemed to firmly establish the Fed’s reputation
for maintaining price stability. Like today, many thought that the
Fed’s reputation was secure. Yet it didn’t take long for accommodative
monetary policy and gradually rising inflation to erode this reputation.
Once that public confidence was lost, increases in the prices of oil
and other commodities in the early 1970s were quickly incorporated into
expectations of higher inflation and then transmitted to the prices of
other goods and services, including wages. Attempts to quell the
inflation with monetary policy were timid, and rising unemployment made
policymakers reluctant to undertake the necessary actions. The result
was an unprecedented surge in inflation that did not end until the Fed,
under Chairman Paul Volcker, took aggressive steps to re-establish the
Fed’s reputation and commitment to low inflation. This came, though, at
the cost of the recession of 1981-82, which took its toll on both
individuals and businesses.

Over the past two decades, central banks around the world have
grappled with ways to deliver on their price stability mandates and
incorporate the lessons of the 1970s into a monetary policy framework.
There is now broad agreement among monetary economists and policymakers
that having a clear numerical objective for inflation — often referred
to as an inflation target — can help a central bank maintain low and
stable inflation by anchoring inflation expectations, enhancing policy
transparency, and increasing central bank accountability for its
actions. Countries that have adopted such a target have tended to have
lower and more stable inflation, better-anchored inflation expectations,
and real activity that is at least as stable as it was before adoption.*
And now more than 20 central banks, including the Reserve Bank of
Australia, the Bank of Canada, the Bank of England, the European Central
Bank, and the Reserve Bank of New Zealand, have adopted an explicit
inflation target. A glaring exception to this worldwide trend is the
U.S. Federal Reserve.

As monetary policymakers begin to contemplate strategies for
exiting this episode of extraordinary accommodation, I believe now is an
opportune time for the Federal Reserve to move its monetary policy
framework into the 21st century. We should adopt an explicit numerical
inflation objective, communicate it to the public, and accept the
responsibility for the outcomes relative to that objective. Let me talk
about how such an objective would fit into the policy framework in the
United States.

The Benefits of Price Stability

Congress has directed the Federal Reserve to conduct monetary
policy “so as to promote effectively the goals of maximum employment,
stable prices, and moderate long term interest rates.” These long-run
objectives complement one another. In fact, most monetary economists,
myself included, agree that focusing on price stability is the most
effective way for monetary policy to achieve its two other goals. Thus,
price stability is at the core of any sound monetary policy framework.

Price stability plays a critical role in the health of the economy
in at least four ways. First, it allows the economy to function in a
more efficient and, therefore, more productive fashion. If prices are
stable, then individuals and businesses can be confident that the
purchasing power of their money will not erode. They will not have to
divert their energies from productive activities in order to hedge
against the risks of inflation or deflation and that allows them to make
better long-run financial plans.

Second, price stability also supports the efficient functioning of
product markets. In a market economy, changes in prices send signals
about the relative supply of and demand for goods and services. These
signals allow individuals and businesses to make informed decisions
about where to allocate scarce resources. Inflation distorts those
signals and makes it more difficult to determine if a price change
reflects a true change in supply or demand or is simply a symptom of
inflation. We see this today in the ongoing debate about the degree to
which the sharp rise in oil prices is a relative price shock, simply
reflecting global supply and demand conditions, or an early indicator of
a general rise in inflation. This uncertainty can delay firms and
households from making the appropriate reallocations of consumption and
investment to alternative sources of energy or other adjustments that
may be called for in response to such a relative supply shock.

Third, price stability allows tax laws, accounting rules, and
contracts to be stated in dollar terms without concerns about changes in
the value or purchasing power of the dollar. For example, tax rates are
often based on dollar amounts or dollar thresholds that are not indexed
by inflation. This means inflation can force individuals into higher
tax brackets even though their real incomes are not rising. This has
been particularly evident in recent years with the alternative minimum
tax, or AMT. Because of the steady upward drift of the price level,
Congress has had to increase the exemption level several times over the
years in order to avoid subjecting more and more individuals to this
additional tax that was once intended to affect only the very wealthy.

Fourth, price stability avoids the unexpected wealth transfers
between lenders and borrowers that occur when there are unexpected
changes in inflation. The S&L crisis of the 1980s was precipitated
in part by the unanticipated inflation in the late 1970s. The S&Ls
had made long-term loans in a low inflation environment, and then saw
the value of these loans plunge and net income turn negative as
inflation rose in the late 1970s and debtors repaid their loans in
substantially devalued dollars. By minimizing these sorts of effects,
price stability helps promote financial stability.

But price stability is more than just an end unto itself.
Economists have come to understand that price stability also promotes
the other two goals of the Federal Reserve’s mandate. First, price
stability works to promote moderate long-term interest rates. Long-term
interest rates include compensation to make up for the loss of the
purchasing power of money that inflation causes. They also include an
additional risk premium to compensate the holders of long-term assets
for uncertainty about future inflation. For these reasons, when
inflation is high, long-term rates tend to be high. Thus, price
stability is an effective means to achieve moderate long-term interest
rates. Indeed, over the medium term, it is the only way in which
monetary policy can achieve such an objective.

Price stability also promotes maximum employment in the medium to
longer term. However, it is important to recognize that monetary
policy’s relationship to the employment part of the Fed’s mandate is
different from its relationship to inflation. While monetary policy
determines the inflation rate over the medium to long run, it cannot
achieve a long-run employment objective that is inconsistent with
economic fundamentals. Maximum employment will vary over time due to
changes in demographics, productivity and technology, labor laws and
practices, taxes, and many other factors that are not influenced by
monetary policy. So while inflation over the medium term is both
observable and controllable through monetary policy, maximum employment
is neither observable nor directly controllable with monetary policy.

Still, price stability can improve the prospects for growth and
employment. When the public knows that the central bank is committed to
low and stable inflation, inflation expectations will remain well
anchored. This increases the central bank’s ability to respond optimally
to economic disturbances that affect real activity in the near term. If
a negative shock implies that the short-term policy rate should fall,
then with stable inflation, long rates will fall as well, making the
impact of the policy change more effective. If the central bank lacks
the commitment or credibility to keep inflation low and stable, lowering
the policy rate could quickly lead to increases in expectations of
inflation that can either completely or partially negate the
effectiveness of the policy change. This is a large part of the reason
why both unemployment and inflation rose together in the 1970s.

Economic instability often goes hand in hand with price
instability. The Great Depression and the Great Inflation were periods
of both economic instability and price instability. In contrast, the
period between the end of the Korean War and the mid 1960s, and the
period from the late 1980s through the end of the century, known as the
Great Moderation, were characterized by low inflation and a growing
economy.

I believe that price stability is an important goal for monetary
policy in the United States and the most effective means for promoting
the two other parts of our statutory mandate. In a modern world of fiat
currencies, only the central bank can deliver on price stability.
Thus, it behooves us as monetary policymakers to contemplate changes to
our policy framework to improve our ability to meet that goal. I
believe setting a numerical inflation objective is one important way to
do that.

The Benefits of an Inflation Target

It is no secret that I have long advocated that the Fed make
explicit its commitment to a numerical inflation objective. It is
consistent with the view of central bankers and monetary economists
around the world and widely viewed as a best practice of central
banking. I see at least three interrelated advantages to being explicit
and public about the goal.

First, it would increase transparency by clarifying what the Fed
means by price stability. By reducing uncertainty, an inflation target
would better align the public’s view of monetary policy with the central
bank’s objectives. This would make policy more effective in promoting
our long-term goals of price stability, maximum employment, and moderate
long-term interest rates.

Second, the willingness of the central bank to publicly announce a
numerical inflation goal it expects to achieve would help make explicit
the Fed’s commitment to price stability, thereby making that commitment
more credible in the minds of the public and market participants. This
would help anchor inflation expectations. Since, as I have discussed,
expectations of inflation influence actual inflation, anchored inflation
expectations would benefit the economy by helping to keep inflation
stable.

Third, an explicit numerical target will increase the Fed’s
accountability and improve communication by making it easier for the
public to monitor the Fed’s monetary policy performance relative to its
mandate. If the Fed failed to achieve its objective, a numerical target
would require the central bank to communicate why it deviated and, more
important, how it planned to return inflation to its objective. In a
democracy, central banks owe the public this transparency and
accountability. In addition, an explicit target would make it harder for
the Fed to use its discretion to deviate from a stable inflation
policy. This, in turn, will increase the credibility of the Fed’s
commitment to establish and maintain price stability, which will help
anchor inflation expectations and produce better economic outcomes.

Now Is the Time for the Fed to Adopt an Inflation Target

These advantages persuade me that the Fed should adopt an explicit
numerical inflation objective. Moreover, in my view, now is an opportune
time to do so. The apparent strengthening of the U.S. economy suggests
that, in the not-too-distant future, monetary policy will have to begin
reversing course from a very accommodative policy stance. As we
choreograph that exit, I believe that the Fed should do all it can to
underscore its commitment to maintaining price stability.

During the recent crisis, many feared that the economy would enter
into a sustained deflationary environment. We had a similar deflationary
scare in 2003. Yet, over the course of both episodes, inflation
expectations remained relatively stable, a circumstance that helped us
avoid this potentially dire situation. Now we are experiencing sharp
increases in oil and other commodity prices. While such price increases
are typically associated with changes in relative supply and demand, we
must not be too sanguine that high unemployment and output gaps will
guarantee that these relative price shocks won’t pass through to higher
general inflation rates, particularly in an environment where monetary
policy is very accommodative. By declaring an inflation objective, the
Fed can underscore its commitment to keep inflation low and stable and
protect against a loss of credibility, which, in turn will keep
inflation expectations anchored despite volatile commodity prices.

Some people may argue that there is no need to articulate a
numerical inflation objective because the Fed has established a strong
record of maintaining low and stable inflation over the last two
decades. But this is not an argument against an explicit target. It is
an argument against commitment. As such, it is an argument that runs
counter to the lessons of the 1970s and the theoretical and empirical
research of the past two decades.

Another argument often heard against establishing an explicit
inflation objective is that it downgrades the maximum employment goal
within the Fed’s mandate. Adopting an inflation objective does not mean
controlling inflation at the expense of economic stability. On the
contrary, it is arguably one of the best means by which the Fed can set
policy that most effectively promotes all parts of its mandate.

At the same time, adopting a numerical objective for inflation does
not imply that we should adopt a numerical target for maximum
employment. Because monetary policy cannot influence the long-term
maximum level of employment or how that maximum rate evolves over time,
it doesn’t make sense to set a numerical target for employment. Indeed,
attempting to chase such a target with monetary policy would likely
result in more instability in both inflation and the real economy, not
less.

Conclusion

Although the Fed has been mostly successful over the past two
decades at maintaining low and stable inflation, adopting an explicit
numerical inflation objective would help ensure that this success
continues. I believe having such an objective in place would prove
particularly useful when we begin to unwind the extraordinary
accommodation measures that we took to mitigate the crisis.

Inflation targets are employed by most of the major central banks
around the world and are considered a best practice of central banking.
Adopting an explicit numerical inflation goal is an important and
natural next step in strengthening the Fed’s monetary policy framework
so that we are better able to deliver on our statutory mandate of
long-run price stability, moderate long-term interest rates, and maximum
employment.

References

Dotsey, Michael. “A Review of Inflation Targeting in Developed Countries,” PDF Federal Reserve Bank of Philadelphia Business Review (Third Quarter 2006).

Truman, Edwin M. 2003. Inflation Targeting in the World Economy. Institute for International Economics, Washington, D.C.

Walsh, Carl E. “Inflation Targeting: What Have We Learned?,” International Finance 12:2 (2009), pp. 195-233.