Charles I Plosser: Perspectives on the US economy and monetary policy
Remarks by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at the Official Monetary and Financial Institutions Forum
(OMFIF), London, 6 March 2014.
* * *
The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC.
Summary
• President Plosser expects growth of about 3 percent in 2014. He also expects the
unemployment rate to continue its steady decline and to reach about 6.2 percent by
the end of 2014. Inflation expectations will be relatively stable, and inflation will
move up toward the FOMC target of 2 percent over the next year.
• President Plosser believes the Federal Open Market Committee has to revamp its
current forward guidance regarding the future federal funds rate path because the
6.5 percent unemployment threshold has become irrelevant.
• President Plosser favors providing more information on policymakers' reaction
function, which indicates how policy will evolve as economic conditions change.
• President Plosser favors a more systematic, less discretionary approach to
monetary policy. He believes it is time to switch from an interventionist mode for
monetary policy to one that is more systematic.
Introduction
I am honored to participate in the Golden Series lectures and to be here in such a historic
hall. The Official Monetary and Financial Institutions Forum is a relatively new organization,
yet it is already establishing itself as an important venue for the exchange of views and ideas
among policymakers and the private sector. It is similar to the Global Interdependence
Center, a think tank based in Philadelphia, which is hosting a conference at the Banque de
France next week, where I will join my friend Governor Christian Noyer. I note with interest
that Governor Noyer will be speaking to you in just a few weeks' time.
Our venue today has an impressive history. The Worshipful Company of Armourers and
Brasiers has been operating at this location since 1346. That is nearly 350 years before the
Bank of England was founded in 1694. Its original building survived the Great Fire of 1666,
and this current building survived the 1940 Blitz. With so much history steeped in these halls,
I hesitate to mention that the Federal Reserve is marking its 100th anniversary this year. The
Federal Reserve Act of 1913 created a uniquely American approach to a central bank - a
decentralized central bank - with 12 independent Federal Reserve Banks around the country
and a Board of Governors in Washington, D.C. This unique governance structure requires
that I forewarn you that the views I express are my own and do not necessarily reflect those
of the Federal Reserve System or my colleagues on the Federal Open Market Committee
(FOMC).
Economic conditions
The U.S. economy is now nearly five years into a recovery that began in June 2009. The
recovery has been lackluster in many ways, yet it has made considerable progress
nonetheless. The unemployment rate, for example, has fallen from its peak of 10.0 percent to
6.6 percent. Employment gains have restored some 7.8 million jobs since the trough,
representing about 90 percent of the jobs lost since the peak. Stock prices have recovered,
housing prices are up, and earnings at many businesses are healthy. It is my general view
that the U.S. economy is on firmer footing today than it has been in several years. This is a
cause for some optimism for continued progress in 2014.
In recent weeks, there has been a blizzard of economic reports, which have come in weaker
than expected. I believe that weakness largely reflects the severe winter weather rather than
a frozen recovery. So, we must be wary of attaching too much significance to the latest
numbers. As a monetary policymaker, I prefer to take a longer view rather than let our
decisions be whipsawed by the most recent statistics, which are often noisy and subject to
revision. Because monetary policy tends to work with a lag, we must keep our attention
focused on the intermediate- to longer-term underlying trends if we are to make wise
decisions.
Based on the latest GDP numbers revised last week, the U.S. economy performed
noticeably better in the second half of 2013 than in the first half. Specifically, real output grew
at a 3.3 percent pace in the second half of the year compared with 1.8 percent in the first
half.
While this is far from the robust growth that many would like to see, it continues to represent
steady progress and an improving economy. My forecast calls for about 3 percent growth in
2014. This is in line with the central tendency of 2.8 to 3.2 percent growth reported by my
colleagues on the FOMC in December 2013.
There has been discussion of some recent weakness in consumer spending, housing starts,
and housing sales. For instance, in January, total retail sales fell by 0.4 percent; housing
starts dropped sharply in January by 2 percent compared with the level of a year ago; and
existing home sales dropped about 5 percent from a year ago. While some softening in home
sales might be expected from the rise in mortgage rates, those rates are still very low by
historical standards, and new home sales surged in January, rising to their highest level
since 2008. Despite the mixed housing data, continued household formation constitutes a
source of growth in housing demand. So, I expect that housing will continue its recovery in
2014, once we get past the severe weather.
Consumer spending, which accounts for more than two-thirds of U.S. GDP, proved to be
quite resilient in 2013, despite the rise in payroll taxes at the start of the year, a government
shutdown, significant uncertainties about future tax policy, and the implications of health-care
reform.
Going forward, I expect that there will be less fiscal drag on the economy in 2014 than we
saw in 2013. Moreover, rising home prices and stock prices have helped improve consumer
balance sheets. I have frequently noted that one reason for the less-than-robust growth in
consumption during this recovery has been the deleveraging efforts by consumers. With
consumers carrying too much debt, spending was inevitably going to give way to more
saving as consumers attempted to restore the health of their balance sheets. That process
has been playing out, and the drag from deleveraging is waning. In addition, steady,
moderate job growth has led to modest increases in income. I foresee somewhat more
robust spending by consumers in the coming year as these trends continue.
Weather also affected recent manufacturing numbers in the U.S. The Philadelphia Fed's
Business Outlook Survey of manufacturers in our region has been a reliable indicator of
national manufacturing trends in the U.S. In February, the diffusion index of current activity
fell into negative territory for the first time in nine months. However, most respondents
attributed the weakness to the severe winter weather. Consistent with such comments,
expectations for manufacturing activity six months ahead increased in February.
On the job front, the January employment report posted payroll gains of 113,000 jobs,
following an increase of 75,000 jobs in December, again most likely reflecting in part the
effect of the unusually severe winter weather.
As we look at the employment averages over several months, the news remains positive.
Based on the latest revision, firms added an average of 194,000 jobs per month in 2013,
which is a somewhat better pace than in 2012. This consistent pace of job growth was
enough to drop the unemployment rate to 6.6 percent in January. I expect that the
unemployment rate will reach about 6.2 percent by the end of 2014, and, if anything, that
may prove too pessimistic. Given the recent trends, an unemployment rate below 6 percent
is certainly plausible.
In terms of the other part of the Fed's mandate, inflation has been running somewhat below
the FOMC's long-run goal of 2 percent. The Fed's preferred measure of inflation is the
yearover-year change in the price index for personal consumption expenditures, or PCE inflation.
It came in at 1.1 percent last year. It is important to defend our 2 percent inflation target both
from below and above. Yet, I anticipate, as the FOMC indicated in its most recent statement,
that inflation will move back toward our target over time. Economic growth is firming, and
some of the factors that have held inflation down, such as the one-time cut in payments to
Medicare providers, are likely to abate over time.
An additional and important determinant of actual inflation is consumer and business
expectations of inflation. I am encouraged that inflation expectations remain near their
longer-term averages and consistent with our 2 percent target. Given the large amount of
monetary accommodation that we have added and continue to add to the economy, I think
there is some upside risk to inflation in the longer term.
Of course, with any forecast, there are risks. While there continues to be some downside risk
to growth, for the first time in years, I see the potential for more upside risk to the economic
outlook. We need to consider this possibility as we calibrate monetary policy.
Monetary policy
So let me turn to some issues for monetary policy. The Federal Reserve has taken
extraordinary policy actions to support the economic recovery. The Fed has lowered its
policy rate - the federal funds rate - to essentially zero, where it has been for more than five
years. Since the policy rate cannot go any lower, the Fed has attempted to provide additional
accommodation through large-scale asset purchases. We are now in our third round of this
quantitative easing.
Since September 2012, the FOMC has added about $1.3 trillion in long-term Treasuries and
mortgage-backed securities to its balance sheet through this program, buying at a pace of
$85 billion a month in 2013. This program, known as QE3, is already twice the size of the last
round of asset purchases initiated in November 2010, known as QE2.
In December 2013, the Committee announced that it would reduce the pace of purchases
from $85 billion to $75 billion per month. In January, it announced a further reduction to
$65 billion. The FOMC is now on a path of measured reductions, which, if continued, will end
the purchase program later this year. If the economy continues to improve, we could find
ourselves still trying to increase accommodation in an environment in which history suggests
that policy should perhaps be moving in the opposite direction.
In addition to asset purchases, the Fed is using forward guidance as a policy tool, which is
intended to inform the public about the way monetary policy is likely to evolve in the future. In
this dimension, the FOMC has indicated that it intends to leave the policy rate near zero well
past the time that the unemployment rate falls below the 6.5 percent threshold. The FOMC
had previously indicated that this was the earliest point at which it would consider raising
interest rates, especially if projected inflation continues to run below the Committee's
2 percent target.
Even though the FOMC has said that it doesn't anticipate raising rates when the economy
crosses that threshold, I believe that with the economy so close to the unemployment
threshold, we face a communications challenge. In particular, we have not described how
policy will be conducted after the unemployment rate falls below 6.5 percent.
Communication challenges
But before we offer further forward guidance, it is important to be clear about what this
forward guidance is supposed to accomplish. As that famous American baseball player Yogi
Berra is reported to have said, "You have to be careful if you don't know where you're going
because you might end up somewhere else."
One way to think of forward guidance is that it is just another step toward increased
transparency and effective communication of monetary policy. This approach seeks to clarify
how policymakers will alter policy as economic conditions change, that is, to describe a
reaction function. By being more transparent about how policy will evolve as a function of
economic conditions, this approach can help the public form more accurate expectations
about the future path of monetary policy.
Economists have learned that expectations play an important role in determining economic
outcomes. When businesses and households have a better understanding of how monetary
policy is likely to evolve, they can make more informed spending and financial decisions. If
policymakers can reduce uncertainty about the course of monetary policy, the economy is
likely to perform more efficiently.
Of course, in order to communicate something about the reaction function, you have to have
one. That means in order to succeed with this approach to forward guidance, policymakers
must be able to agree on how they will systematically respond to changes in economic
conditions. To be useful, however, the reaction function need not be mechanistic. Qualitative
information about such a function and how it will be implemented can also be useful and
meaningful. Nevertheless, some degree of commitment to abide by the specified reaction
function is necessary if the communication is to achieve the desired result of reducing policy
uncertainty and providing meaningful forward guidance.
A somewhat different rationale or view of forward guidance is that it is a way of increasing
accommodation when the policy rate is at or near the zero lower bound. Some models
suggest that when you are at the zero lower bound, it can be desirable, or optimal, to indicate
that future policy rates will be kept "lower for longer" than might otherwise be the case. Thus,
policymakers may want to deliberately commit to deviating from what they would otherwise
choose to do under normal conditions, such as following a Taylor-like rule. In these models,
such a commitment would tend to raise inflation expectations and lower long-term nominal
rates, thereby inducing households and businesses to spend more today.
This approach asks more of forward guidance than just articulating a reaction function. It
takes more credibility and commitment because it requires policymakers to directly influence
and manage the public's beliefs about the future policy path that differs from how
policymakers behaved in the past. As I have indicated in previous speeches, this approach to
forward guidance can backfire if the policy is misunderstood.1 For example, if the public
hears that the policy rate will be lower for longer, it may interpret this news as policymakers
saying that they expect the economy to be weaker for longer. If that is the interpretation of
the message, then the forward guidance will not succeed and may even weaken current
spending.
The FOMC has not been clear about the purpose of its forward guidance. Is it purely a
transparency device, or is it a way to commit to a more accommodative future policy stance
to add more accommodation today? This lack of clarity makes it difficult to communicate the
stance of policy and the conditionality of policy on the state of the economy.
I believe there is another - perhaps more fundamental - tension underlying forward guidance
and communication. Forward guidance in either of the two approaches I have discussed
requires a degree of commitment to conduct future policy in some particular manner.
Commitment is central to the success of either approach. Yet, I would suggest that the old
"rules versus discretion" debate is alive and well. This, of course, is not a new tension within
the FOMC, nor is it one that is likely to go away in the near term. But the heightened weight
and prominence given to forward guidance as a policy tool has certainly shined a spotlight on
this longstanding debate.
The desire to maintain flexibility to respond to "events on the ground" is a strong one. One
can make the case that discretion is deeply ingrained in most policy institutions, particularly
the Fed. Yet, the desire to maintain discretion is anathema to the commitment required for
successful forward guidance. Policymakers cannot maintain discretion and simultaneously
commit to forward guidance and expect that guidance to be effective.
Conclusion
In summary, I believe that the U.S. economy is continuing to improve at a moderate pace.
We are likely to see growth of around 3 percent in 2014. Prospects for labor markets will
continue to improve, and I expect the unemployment rate will continue to decline, reaching
6.2 percent or lower by the end of 2014. I also believe that inflation expectations will be
relatively stable and that inflation will move up toward our goal of 2 percent over the next
year.
On monetary policy, we must back away from increasing the degree of policy
accommodation in a manner commensurate with an improving economy. Reducing the pace
of asset purchases in measured steps is moving in the right direction, but the pace may
leave us well behind the curve if the economy continues to play out according to the FOMC
forecasts.
Even after the asset purchase program has ended, monetary policy will still be highly
accommodative. As the expansion gains traction, the challenge will be to reduce
accommodation and to normalize policy in a way that ensures that inflation remains close to
our target, that the economy continues to grow, and that we avoid sowing the seeds of
another financial crisis.
Let me conclude with this thought. Over the past five years, the Fed and, dare I say, many
other central banks have become much more interventionist. I do not think this is a
particularly healthy state of affairs for the central banks or our economies. The crisis in the
U.S. has long passed. With a growing economy and the Fed's long-term asset purchases
coming to an end, now is the time to contemplate restoring some semblance of normalcy to
monetary policy.
In my view, the proper role for monetary policy is to work behind the scenes in limited and
systematic ways to promote long-term growth and price stability. But since the onset of the
financial crisis, central banks have become highly interventionist in their efforts to manipulate
asset prices and financial markets in general as they attempt to fine-tune economic
outcomes. This approach has continued well past the end of the financial crisis. While the
motivations may be noble, we have created an environment where "it is all about the Fed."
Market participants focus entirely too much on how the central bank may tweak its policy,
and central bankers have become too sensitive and desirous of managing prices in the
financial world. I do not see this as a healthy symbiotic relationship for the long term.
If financial market participants believe that their success depends primarily on the next
decisions of monetary policymakers rather than economic fundamentals, our capital markets
will cease to deliver the economic benefits they are capable of providing. And if central banks
do not limit their interventionist strategies and focus on returning to more normal
policymaking aimed at promoting price stability and long-term growth, then they will simply
encourage the financial markets to ignore fundamentals and to focus, instead, on the next
actions of the central bank.
I hope we can find a way to normalize the role of monetary policy to one that is less
interventionist, less discretionary, and more systematic. I believe our longer-term economic
health will be the beneficiary.