Charles I Plosser: A longer-term view of the US economy and monetary
policy
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, to the Charlotte Economics Club, Charlotte, North Carolina,
3 December 2014.
* * *
The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC.
Highlights
• President Charles Plosser gives his views on the U.S. economy and discusses why
it is important to take a longer-term view of economic data.
• President Plosser shares some thoughts about the stance of monetary policy and
the advantages of raising rates gradually and starting sooner rather than being
forced to raise them abruptly later.
President Plosser also discusses how policy rules can offer useful guideposts for
•
policymakers and the public in assessing and communicating the stance of
monetary policy.
Introduction
Thank you for the invitation to be here today. The Charlotte Economics Club has welcomed
many leading Federal Reserve voices to this podium over the years, including a number of
my fellow Fed presidents. You have heard from President Jeff Lacker of the Richmond Fed,
which has its Charlotte Branch over on East Trade Street, as well as Presidents Richard
Fisher of Dallas and Dennis Lockhart of Atlanta. So I am pleased to have been included
among your distinguished guests.
On November 16, the Federal Reserve observed the 100th anniversary of the opening of all
12 Federal Reserve Banks around the country on the same day. These institutions along
with the Board of Governors in Washington, D.C., comprise our nation's decentralized central
bank. This decentralized structure is one of the System's great strengths. Not only does it
promote a diversity of views, but it also helps to build public trust and preserve
independence. However, it requires that I begin by reminding you that the views I express
today are my own and do not necessarily reflect those of the Federal Reserve System or my
colleagues on the Federal Open Market Committee (FOMC).
Your program chair, Professor Rob Roy McGregor, has spent a great deal of his academic
career studying the workings of the FOMC - including the use of power by the Chair and the
nature of consensus building and dissent within the Committee. Interestingly, some of this
work has been coauthored with a former colleague of mine at the Philadelphia Fed, Todd
Vermilyea, who now works at the Board of Governors.
Today, I plan to talk about the importance of taking a longer-term view in setting monetary
policy. We live in a 24-hour news cycle that focuses a lot of time and energy on analyzing the
tea leaves from the daily onslaught of new economic data at our disposal. Yet, I believe it is a
mistake for policymakers to focus too intently on the most recent numbers to justify a policy
decision. Our data are always noisy and often subject to substantial revision, as we just
witnessed with last week's GDP revisions and as we see regularly with the monthly
employment report. Instead, we must focus our attention on the underlying trends and the
likely path of the economy over the intermediate to longer-term horizon.
One reason why policymakers must think long term is that the effects of monetary policy
actions on inflation and employment may not be felt for many quarters and maybe years in
the future. Thus, the near term path of the economy is unlikely to be altered in any significant
way by today's policy choices. We must look further ahead in assessing the appropriate
stance of monetary policy. Of course, there is a great deal of uncertainty about the future and
that too has implications for how we should approach policy.
I will begin with a brief overview of the economy as one policymaker sees it as we near the
end of 2014.
Economic conditions
Over the past year, we have seen encouraging signs in the economy. The most recent
estimate of annualized real GDP growth in the third quarter was 3.9 percent, which followed
strong growth in the second quarter of 4.6 percent. Taking a longer view, growth from the
third quarter of last year to this year was 2.4 percent. But this includes a negative 2.1 percent
growth rate in the first quarter of 2014 that was a consequence of a severe winter and was
largely transitory in nature. We are seeing continued strength in personal consumption,
especially in durable goods, as well as business fixed investment, which marked the
strongest two quarter growth in investment by businesses in nearly three years.
GDP growth has averaged 2.3 percent over the 21 quarters of the recovery since mid-2009.
That is a half point below the 5-year growth rates measured during most of the 2000s before
the recession, which is, in part, why this recovery is often seen as being moderate or modest
from an historical perspective.
Nonetheless, we have seen a sustained improvement in the manufacturing sector. The
November reading from the Philadelphia Fed's Manufacturing Business Outlook Survey
indicated very strong growth in manufacturing activity. Even more encouraging are the
sustained increases we have witnessed in this sector. After a mediocre performance from
mid-2011 to mid-2013, the index has now been positive for nearly 18 consecutive months,
with the only aberration in February 2014 during the depths of our severe winter weather.
Our index is often viewed as a useful indicator of national manufacturing activity, and indeed
the national ISM manufacturing index has also shown solid performance over the past
18 months.
The labor market has also strengthened over the year. Employers added jobs at an average
rate of 229,000 per month in the first 10 months of the year, which is 18 percent higher than
the rate in 2013, and it's the highest we have seen at any point in the recovery. This
acceleration in job growth has helped bring the unemployment rate down to 5.8 percent as of
October, compared with 7.2 percent a year ago.
Over the course of this recovery, the unemployment rate has fallen from a peak of 10 percent
in October 2009 to 5.8 percent today. Other measures of unemployment have also declined.
For example, the measure called U6, which includes marginally attached workers and those
working part time for economic reasons, has fallen from its peak of 17.2 percent to
11.5 percent.
Inflation, for the moment, remains well contained. The personal consumption expenditures,
or PCE, price index, the measure of inflation preferred by the FOMC, registered a
1.4 percent increase over the 12 months through October. It is running somewhat below the
FOMC's stated longer-term target of 2 percent, but it remains above the level that should
stoke concerns of sustained deflation.
Falling energy prices are generally good news for consumers and a favorable development
for the economy going forward. In the short term, the decline in the relative price of energy
will show up in lower headline inflation, but as energy prices stabilize, headline inflation will
increase. Policymakers tend to look through such volatile and transitory price changes to
assess the underlying trend in inflation. The core PCE index, which excludes food and
energy, is a bit higher than the overall measure, increasing 1.6 percent over the 12 months
through October. Other measures of inflation, including those that attempt to reduce the
weight given to large outliers in any given month, all tend to suggest that inflation is running
between 1.5 percent and 2 percent. Given the precision with which we can measure such
things, I find this outcome satisfactory. Nevertheless, I anticipate that the FOMC will conduct
policy over time in such a manner that inflation will gradually move toward the Fed's
2 percent target. Private sector forecasters seem to share this view as the Philadelphia Fed's
most recent Survey of Professional Forecasters shows that long-term inflation expectations
remain stable at 2 percent.
Monetary policy
In my discussion of the economy, I have emphasized the longer-run path of the recovery
rather than the month-to-month fluctuations. Viewed in this context, it is clear that the
economy has come a long way since the recovery began in June 2009. To me, that means
we should no longer be conducting monetary policy as if we were still in the midst of a
financial crisis or in the depths of a recession.
The financial crisis was an extraordinary event, and much of the commentary on monetary
policy has focused on the actions of central banks in response to the financial crisis. That is
appropriate and understandable. Yet, there is another lesson to be learned from the past six
years that I think is important to recognize. And that is how difficult it is for monetary policy to
fine-tune real growth in the economy. Despite the FOMC's stated desire and aggressive
actions to accelerate the pace of the recovery, growth has proceeded at a moderate pace
since the end of the crisis. Monetary policy has simply not proved to be the panacea that
many had hoped. As I have argued on a number of occasions, I believe we have come to
expect too much from monetary policy. We would be better served by greater humility and
lowered expectations of the potential for monetary policy to manage real economic growth
and employment.
Ten years ago, I suspect most commentators would have told you that six years of a
nearzero federal funds rate target and more than $3.5 trillion of long-term asset purchases by the
Fed would likely produce an economic boom in the near term and would risk inflation in the
longer term. Well, although we have experienced modest growth, we have not experienced a
boom, and the jury remains out as to whether inflation will materialize as a consequence.
Some argue that the absence of the boom is because the Fed didn't do enough - more was
needed to offset the constraint of the zero lower bound on nominal interest rates. Of course,
there is an alternative hypothesis: Monetary policy was not capable of offsetting or mitigating
the sorts of real challenges the economy was facing. Distinguishing between these two
hypotheses will undoubtedly be the subject of intense research in the coming decades. After
all, economists are still studying the policy choices and their effects during the Great
Depression eight decades ago.
But let me turn our attention to how monetary policy should evolve going forward. I began my
remarks by noting that monetary policy should focus on the intermediate to longer term and
be less sensitive or reactive to short-run and transitory movements in the data. To that end, I
see the economy continuing to improve with real growth averaging about 3 percent in 2015
before coming back down to its long-term trend growth rate of about 2.4 percent.
Employment will continue to expand, and inflation will move closer to our 2 percent target.
While people can disagree about the extent to which the labor market has healed, it is clear
that the labor market is in much better shape than it was in 2009 when unemployment
reached its peak of 10 percent. The economy has come a long way, and monetary policy
should reflect such progress.
This progress suggests that monetary policy should begin to normalize. Keeping the funds
rate target near zero when inflation is close to our goal and the economy is near full
employment is both unprecedented and risky in my view. Waiting too long to begin the
process of raising the policy rate risks facing the possibility that the rate may have to
increase rapidly when the time comes and that could prove unnecessarily disruptive. And
waiting could also risk a more rapid pickup in inflation.
Of course, policymakers face many uncertainties, and so they must be prepared to adjust
policy as the underlying trends in inflation and the real economy evolve. So, how should a
central bank best inform the public about those uncertainties and the prospective path of
policy?
The appropriate way to communicate the future of policy is to describe in a general way a
reaction function. That is to describe what key economic variables influence the setting of
policy and to give a sense of how policy will change in response to changes in those
variables. Over the past several years, I have criticized policy messages that suggest that
calendar time is a relevant metric for determining a policy action. We must avoid such
datebased forward guidance, whether it uses specific calendar dates or more vague references
alluding to a "considerable period" of time. As policymakers, we do not know what the future
holds, so forward guidance in this form cannot be very credible.
Unfortunately, it is unlikely that policymakers will adopt a specific reaction function in the near
term. Yet, there are numerous examples of such systematic approaches or reaction functions
that can help us to gauge the stance of policy. Some of these reaction functions have been
shown to be robust in a variety of circumstances and useful in describing past monetary
policy behaviors. They can, I believe, provide useful guidelines for assessing the stance and
the likely path of monetary policy. They can also be useful in communicating policy to the
public. I frequently consider such reaction functions as I think about policy. These are
typically Taylor-like rules named for the Stanford University economist John Taylor who first
proposed them in the early 1990s. These policy rules typically call for the targeted funds rate
to respond to deviations of inflation from some desired target and to deviations of output from
some measure of potential - sometimes referred to as economic "slack" or the "gap."
Sometimes such gaps are translated into deviations from full employment.
These policy rules can offer useful guideposts for policymakers and the public in assessing
the stance of monetary policy, and communicating more about such guideposts would
enhance transparency and help make policy more systematic. Thus, there is no need to
mechanically follow any particular rule, and judgment will always be required. Yet,
policymakers and the public should be very cautious when they call for policy rates to deviate
in important or significant ways from these guideposts. Making such judgments should
require careful analysis, and the justification for deviating from such guidelines should be
clearly communicated to the markets and to the public.
A monetary policy strategy such as I have just described could be communicated through a
regular Monetary Policy Report, perhaps published quarterly. The report would offer an
opportunity to reinforce the underlying policy framework of the Committee and how it relates
to current and expected economic conditions.
Publishing a Monetary Policy Report with an assessment of the likely near-term path of
policy rates, in conjunction with its economic forecast, would also provide added discipline for
policymakers to stick to a systematic, rule-like approach. Communication about that path, in
turn, gives the public a much deeper understanding of the analytical approach that guides
monetary policy, thus making policy more transparent and predictable.
In the current environment, an assessment of a variety of these robust rules suggests that
the funds rate target is no longer constrained by the zero lower bound. These rules indicate
that liftoff of the funds rate target from zero should have already occurred or should occur in
the very near future. It is important to point out that all of these rules recognize and take into
account the fact that the inflation rate remains somewhat below the FOMC's target of
2 percent. Nevertheless, they do not call for maintaining the funds rate target near zero.
These rules are helpful because they not only suggest when liftoff should occur, but they
offer guidance about the future path of rate changes, given the likely direction of the
economy - that is, forecasts of inflation and employment "gaps." Even more important is that
if the forecasts of the future change, these guideposts can highlight how the entire policy
path is likely to evolve. As such, they are capable of better aligning the public's expectations
of policy with those of the FOMC, making the conduct of monetary policy more accountable
and more efficient.
Conclusion
In conclusion, the U.S. economy continues to recover at a moderate pace. Although we have
not witnessed the strong bounce back from the depths of the recession that some
anticipated, the recovery has been somewhat remarkable in the steadiness with which it has
progressed. Labor markets continue to heal, and their stronger-than-expected recovery
should serve to underpin continued economic expansion. Consumer balance sheets are
much improved, and individuals have regained significant fractions of the wealth they lost
during the crisis. That gives me additional confidence that the economy is now operating
fairly normally and that policy should reflect that normalization.
Policy can also be made more transparent and effective by specifying more completely the
variables that guide policy and the general way that one can expect policymakers to react to
those variables. To this end, I believe the FOMC should move forward to describe in a
qualitative way its reaction function and then communicate our actions and decisions in
terms of this reaction function. A detailed Monetary Policy Report could be a useful vehicle
for such enhanced communication by discussing a range of robust policy rules. Placing
policy choices in such a context will lead to a more systematic approach to policy and one
that is more transparent and predictable.