In a speech which on the surface is meant to convey the skepticism of the Charles Plosser over QE2, the Philadelphia Fed president admits that much more QE may ultimately be needed. "If the economy grows more quickly than I currently anticipate, the purchase program will need to be reconsidered and perhaps curtailed before the full $600 billion in purchases is completed. On the other hand, if serious risks of deflation or deflationary expectations emerge, then we would need to consider whether expanded asset purchases should be used to address these risks." And much more deflation will eventually emerge especially for large scale purchases which rely on credit procurement (coupled with increasing inflation in commodities which are first degree liquidity derivatives): after all, the collapse in the shadow banking system, and the M3, are all the matter, and the Fed has no control over these (now that European greater fool securitized investors are extinct). It is precisely the Fed's QE3 response that should start being factored in. As everything else is noise, we will immediately present the latest meltdown in the shadow economy when the quarterly update is posted at noon on December 9.
Economic Outlook and Monetary Policy
Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
32nd Annual Economic Seminar, Sponsored by the Simon
Graduate School of Business, Rochester Business Alliance, and JPMorgan
Chase & Co., Rochester, NY, December 2, 2010
Thank you for that warm welcome. I am delighted to be back in
Rochester. It is always wonderful to see old friends and familiar faces.
Having participated in this event for 32 years, and having lived here
for nearly as long, Rochester will always feel like home to me. I have
enjoyed the richness of the discussions we have had over the years,
through both good and bad forecasts, and I am honored that the Simon
School, the Rochester Business Alliance, and JPMorgan Chase continue to
welcome me back.
Over the last few years, both here and elsewhere, I have noted that
these are interesting and challenging times for the economy and for
policymakers. I suspect that we all would welcome a little more boredom
and a little less challenge. Nevertheless, challenges remain and today I
will discuss current monetary policy, including the Fed’s decision to
begin a new round of large-scale asset purchases. Because appropriate
monetary policy is forward looking and conditional on the outlook for
the economy, I will start by highlighting my views on our nation’s
economic recovery and my outlook for growth and inflation. Before
continuing, I should note that my views are my own and not necessarily
those of the Federal Reserve Board or my colleagues on the Federal Open
The Economic Outlook
When we met a year ago, I told you that I believed the economy was in
a recovery and that I had become more confident that it would be a
sustainable one. We now know, thanks to the Business Cycle Dating Committee of the National Bureau of Economic Research,
that the recession ended in June 2009. However, the pace of the
recovery since then has been uneven and slower than anyone would like.
Yet, this slow pace was not unexpected, given the severity of the
recession and the financial nature of the shocks that precipitated it.
Remember the economy lost more than 8 million jobs — a 6 percent decline
in employment — and households lost more than $12 trillion in net
worth. So, some necessary rebalancing is taking place.
Consumers and businesses are in the process of deleveraging and
rebuilding their savings. Activity in the housing industry will continue
to languish until housing inventories are reduced. State and local
governments are cutting spending to make up for lower tax revenues. And
the unemployment rate remains high at 9.6 percent, as displaced workers
vie for available open positions. Uncertainties surrounding fiscal
policies and the costs they will impose on businesses have also weighed
down the recovery.
So, while we are in our sixth quarter of economic recovery, it
doesn’t feel like one for many people. Admittedly, growth for 2010 will
be somewhat lower than the 3 percent annual rate that I projected a year
ago. We started out the year with a fairly nice rebound. Real GDP grew
at a 3¾ percent pace in the first quarter as firms began to restock the
inventories they had drastically cut during the recession. House sales
were boosted temporarily by the homebuyers’ tax credits, which pulled
sales forward. However, when the credits ended, sales dropped off
sharply. So going into late spring and early summer, the pace of the
recovery slowed to less than 2 percent, due in part to the expected
decline in housing sales. The mood and tone of the recovery were further
shaken by the sovereign debt problems in Europe, which led some to
worry that the economy could dip back into recession. While this loss of
momentum did cause me to revise down my forecast for the year, I was
less concerned about a double dip. History has taught us that recoveries
are rarely a smooth upward trajectory. Yet, the most recent data
suggest that the economy is emerging from the summer doldrums. Growth in
the third quarter accelerated to 2½ percent and readings on consumer
spending and manufacturing activity have also picked up.
As we end 2010, I now project that GDP growth will be around 2½
percent for this year and will pick up to 3 to 3½ percent annually over
the next two years. A key to this growth will be increased private
demand, which is essential for a sustainable recovery. While neither
business spending nor consumer spending is likely to take off rapidly, I
do expect continued improvement in economic conditions that will
support moderate growth going forward. As with all forecasts, this
projection carries some risks. But for now, I expect moderate growth
overall, with strength in some sectors offsetting weakness in others.
Housing is one sector that I expect to remain weak. We entered the
recession highly overinvested in residential real estate, and the sector
is likely to remain depressed for a while longer. Commercial real
estate markets are also weak. Nonresidential construction spending
declined this year, and I do not see much growth until after the economy
is well into a healthy expansion.
In contrast, business spending on plant and equipment is
strengthening. While some smaller firms report difficulties in getting
access to credit, banks have begun to ease credit terms and loan rates
are at historic lows. Larger firms have been able to finance investment
out of retained earnings or to issue new debt on very favorable terms.
Some of these investments have been used to replace aging equipment;
some have gone toward productivity improvements, which are good for the
economy in the long run.
The Philadelphia Fed’s monthly Business Outlook Survey of regional manufacturers showed significant improvement in general activity, orders, and shipments in November,
following some weakness during the summer months. The survey’s measures
of expected future activity indicate that businesses are becoming more
optimistic as well. So I expect business to continue to make these fixed
investments at a healthy pace over the coming year.
Consumer spending, though, makes up about 70 percent of economic
activity in the U.S., so the speed of the overall recovery will depend
on how the household sector fares. Even during recessions, it is rare to
see sustained declines in consumer spending. Yet in 2008, households
cut their spending by over 1¾ percent (measured fourth quarter over
fourth quarter). This was the first yearly decline since 1980, and the
largest since World War II. The fall in house prices and the decline in
equity portfolios hit households hard, destroying the net worth that had
supported spending. Additionally, job losses have meant lower incomes.
Concerns about future job losses caused consumers to retrench. However,
households are now in the process of shoring up their balance sheets. As
debt levels fall, and savings are rebuilt, consumers will be in a
better position to spend. But with unemployment remaining stubbornly
elevated, aggregate wealth will recover only slowly. Those who have lost
their homes or spent down their savings while unemployed will recoup
their losses only over time. This year, consumer spending is up at a 3
percent pace. I don’t expect a stronger rebound without more improvement
in the labor markets.
So far, the private sector has added over a million jobs this year,
reflecting some of the reallocation of displaced workers into new
positions. Unfortunately, the pace of employment growth hasn’t been
strong enough to make much of a dent in the unemployment rate. When we
met last year, the unemployment rate was 10 percent. Over the course of a
year, it has fallen less than half a percent to 9.6 percent, as noted
earlier. Like most forecasters, I believe that the moderate pace of the
recovery in output growth suggests that we will continue to see
improvement in labor markets, but that improvement will be a gradual
one. I expect the unemployment rate will fall to around 8 to 8½ percent
by the end of next year. I wish I could forecast a faster improvement,
but it will take time to resolve the difficult adjustments now under way
in the labor markets. The contraction in the real estate sector and in
sectors closely related to residential construction, such as mortgage
brokerage, means that many workers will likely need to find jobs in
other industries and this will take time. The productivity gains
occurring in other sectors also suggest that many workers may need
updated skills to find their next job. This may be particularly relevant
for the long-term unemployed. Monetary policy will not help these types
of adjustments in the labor markets go any faster.
Unlike employment, inflation is ultimately a
monetary phenomenon. Headline CPI inflation has been near 1 percent 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 percent this year,
down from 1¾ percent 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. Nominal GDP has been growing at an annual rate of more than 4
percent this year. In contrast, during Japan’s lost decade of the
1990s, when deflation was a serious problem, nominal growth was
essentially zero. Responders to the Philadelphia Fed’s fourth-quarter Survey of Professional Forecasters
see only a slight chance of deflation next year. While inflation is
currently lower than the 1½ to 2 percent level many monetary
policymakers would like to see, it does not follow that sustained
deflation is imminent or even likely. It is useful to remember that the
U.S. saw average consumer price inflation of just 1.3 percent through
most of the 1950s and early 1960s. This period of low inflation did not
lead to fears of deflation nor did it lead to economic stagnation.
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.
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 percent over
the course of the next year.
With inflation currently running lower than what many policymakers
would prefer, and with unemployment remaining very high, the FOMC voted
in November to once again begin purchasing assets to expand its balance
sheet. The FOMC stated its intention to purchase an additional $600
billion of longer-term Treasury securities by the end of the second
quarter of 2011.
The public has dubbed this recent asset purchase program “QE2,” which
does not refer to the famous ocean liner but to the Fed’s second round
of asset purchases — what some call quantitative easing. Nearly two
years ago, after the Fed had reduced the federal funds rate to near
zero, it began a program to purchase up to $1.75 trillion in agency
mortgage-backed securities, agency debt, and long-term Treasuries. This
purchase program was completed in March 2010. If the Fed completes the
full amount of the second round, the Fed’s balance sheet will have more
than tripled since mid-2007. The amount of excess reserves held by banks
will approach $1.5 trillion.
Chairman Bernanke has stated that the intention of the current
program is “to support the economic recovery, promote a faster pace of
job creation, and reduce the risk of a further decline in inflation.”1
Proponents expect the security purchases to lower longer-term interest
rates through a portfolio balance effect. That is, as the supply of
longer-term Treasuries available to the public is reduced, prices of
Treasuries should rise, which means yields should fall, to induce the
public to willingly hold the reduced supply. Yields on similar assets
are expected to fall as the public rebalances portfolios away from the
asset with reduced supply toward other similar assets. Just as in
conventional monetary policy, lower interest rates would stimulate
business and consumer demand and increase exports, thus lending support
to the recovery. In some models, the increase in demand leads to a rise
in price levels.
I would note that the U.S. 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. The
Treasury would, of course, face interest rate risk if, when the time
came to roll over this short-term debt, interest rates were higher,
costing the taxpayer more to fund the debt. Yet, the Federal Reserve
also faces interest rate risk by purchasing these long-term government
bonds. If rates go up and the Fed were forced to sell the bonds in order
to prevent inflation, the Fed would take a loss — but so would the
Treasury, since the Fed would not be able to remit as much income back
to the Treasury as it otherwise could. Thus, the public bears the same
risk exposure whether the policy is conducted by the Fed or the U.S.
Because the policy had been anticipated well before the Fed took
action in November, there had already been considerable public
discussion of the pros and cons of the second round of asset purchases.
At that time, based on my reading of the economic outlook, I expressed
the view that I did not think the benefits outweighed the costs.
I am still somewhat skeptical that we will see much of a stimulative
effect from the new round of purchases. The Fed’s first purchase program
worked to lower interest rates, although estimates vary quite a lot.
Some studies suggest that the effect was 30 to 60 basis points. Others
found a much smaller impact.2
Yet, these purchases were done at a time when financial markets were
highly disrupted and asset risk premiums were extremely elevated. 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.
Thus, I think that the benefits of the purchase program may be
modest. On the other hand, one cost of expanding the Fed’s balance sheet
is that it will complicate our exit strategy from a very accommodative
monetary policy, when that time comes.
History tells us that exiting from an accommodative monetary policy
is always a bit tricky. It is easier to cut rates than it is to raise
them. As I discussed last year, monetary policy must be forward looking
because it works on the economy with a lag. This means that the Fed will
need to begin removing policy accommodation before the unemployment
rate has returned to an acceptable level in order to avoid overshooting,
which would result in greater instability in the economy.
While the high level of excess reserves is not inflationary now, as
the economic recovery strengthens, the Fed must be able to remove or
isolate these reserves to keep them from becoming what I have called the
kindling that could fuel excessive inflation. In other words, if banks
began to put the reserves to use in the same manner as they did before
the crisis, money in circulation would increase sharply. We do not know
when that will happen or how long it will take for the banking system to
make the adjustment. To address this looming challenge, the Fed is
developing and testing tools to help us prevent such a rapid explosion
in money. But, of course, we won’t know for certain how effective these
new tools are until we need to use them in our exit strategy. Nor do we
know how rapidly or how high we may need to raise rates.
Because the Fed’s monetary policy must be forward looking, the hue
and cry from many quarters may be quite loud when it is time to act.
Even with the best of intentions, if we don’t act aggressively and
promptly, we may find ourselves behind the curve and at risk for
substantial inflation. I think we need to bear in mind this future
potential complication when considering further expansion of the Fed’s
The November FOMC statement
indicated that we will regularly review the purchase program in light
of incoming economic information and adjusting it as needed to foster
our long-run goals of price stability and maximum sustainable
employment. I take this intention to regularly review the program
seriously, and I will be looking for evidence of the hoped-for benefits
as I evaluate the program before each meeting. If we do not see these
benefits, I would not infer that we merely need to increase the size of
the program. Rather, I would take this as evidence that we need to
rethink the analysis of costs and benefits that led us to this policy in
the first place. If the economy grows more quickly than I currently
anticipate, the purchase program will need to be reconsidered and
perhaps curtailed before the full $600 billion in purchases is
completed. On the other hand, if serious risks of deflation or
deflationary expectations emerge, then we would need to consider whether
expanded asset purchases should be used to address these risks.
However, we would then need to clearly communicate that we were taking
this step to combat deflation and deflationary expectations, and not as
an action to speed up the recovery.
In conclusion, our nation’s economy is now emerging from the worst
financial and economic crisis since the Great Depression. A relatively
slow but sustainable economic recovery is under way. I expect growth to
be around 2½ percent this year, heading up to 3 to 3½ percent annually
over the next two years.
As the economy continues to gain strength and optimism continues to
grow among businesses, hiring will strengthen. As it does, the
unemployment rate will decline, but it will be a gradual decline. The
shocks we experienced were huge, and it will take some time for the
imbalances in labor markets to be resolved.
The Federal Reserve remains committed to promoting price stability.
This is the most effective way in which monetary policy can contribute
to economic conditions that foster maximum sustainable employment.
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. 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