Charles I Plosser: A perspective on the economy and monetary policy
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, to the Greater Philadelphia Chamber of Commerce,
Philadelphia, Pennsylvania, 14 January 2015.
* * *
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 the
importance of four principles to sound monetary policy.
• President Plosser believes that the appropriate way to make policy systematic, or
rule-like, is to base policy decisions on economic conditions. Monetary policy should
be data dependent, not date dependent.
He thinks policymakers should describe the reaction function that determines how
•
the current and future policy rates will be set depending on economic data.
President Plosser proposes the creation of a regular monetary policy report to help
•
improve communication while enhancing the transparency and accountability of the
Fed.
Introduction
Thank you, Richard (Green, CEO and vice chairman of Firstrust). I am delighted to speak
with so many of Philadelphia's business leaders this morning. A couple of years ago, Richard
served on the Philadelphia Fed's advisory council of community bankers and as our District's
representative to a similar council at the national level. So, he knows firsthand about the
intricacies of the Fed's structure as America's decentralized, central bank, with
12 independently chartered Federal Reserve Banks, overseen by the Board of Governors in
Washington, D.C.
It is a model that has worked for a century, bringing together a rich mosaic of perspectives as
we discuss policy. Yet, it requires that I remind the audience 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).
I will begin with a brief overview of the economy. Yet, because you have already heard
several views of the year ahead - including the report of your membership survey - I plan to
spend most of my time giving you a longer-term perspective on what I think is a sound
approach to monetary policy.
Economic overview
We began 2014 with a severe winter, which led to a first-quarter decline in GDP of
2.1 percent. After that bleak start, though, we saw robust GDP growth in the second and third
quarters of 4.6 percent and 5.0 percent, respectively. The third-quarter estimate was the
strongest quarterly growth in more than a decade. More important, four of the past five
quarters have seen growth rates of 3.5 percent or more, with only the wintry first quarter as
the exception. The Philadelphia Fed's Survey of Professional Forecasters estimated that
fourth-quarter growth would moderate to 2.7 percent. Some recent tracking estimates are
now placing it over 3 percent. We won't know what the official first estimate will be until the
end of this month, but even that slight slowdown would lead to full-year growth in 2014 that is
a bit higher than many had expected.
Looking forward, I believe we will see growth averaging about 3 percent in 2015 before
edging down to a long-term trend growth rate of about 2.4 percent.
Recent data also show a stronger contribution from consumer spending, which accounts for
more than two-thirds of the GDP. Significant improvement in household balance sheets and
a stronger employment picture have helped support a more confident consumer. Real
personal consumption expenditures (PCE) have grown at a 4.5 percent annual pace over the
past three months.
Manufacturing also continues to show strength. Recent figures from the Philadelphia Fed's
Manufacturing Business Outlook Survey, the national ISM manufacturing index, and
industrial production all indicate that the manufacturing sector is expanding at a healthy
pace.
Strong consumer and business spending has supported consistent gains in the labor market.
Nonfarm employment expanded by 252,000 jobs in December, giving us 11 consecutive
months of 200,000-plus job growth. For the full year, we had average monthly gains of
246,000 in 2014, compared with 194,000 in 2013. In fact, we added nearly 3 million jobs in
2014, the most in a calendar year since 1999. Those job gains have led to a steady decline
in the unemployment rate, which is now 5.6 percent, down more than a point from a year
ago. Even the broader measure of unemployment, referred to as U-6, which includes
marginally attached workers and those working part time for economic reasons, has fallen to
11.2 percent.
Inflation is running at about 1.5 percent, which is below the Fed's long-term target of
2 percent, as measured by the year-over-year change in the price index for PCE. Yet, I and
many other economists anticipate that inflation will gradually move toward the target as the
transitory effects of lower oil prices fade.
In summary, I believe the economy has returned to a more normal footing, and as such, I
believe that monetary policy should follow suit. In doing so, I believe we should strengthen
our commitment to four fundamental principles of sound central banking. During the past
eight years, I have spoken and written frequently about ways to improve the framework we
use for making monetary policy decisions. In my view, the monetary policy framework is most
effective when the central bank:
• commits to a set of clearly articulated objectives that can be feasibly achieved by
monetary policy;
• conducts monetary policy in a systematic, rule-like manner;
• communicates its policies and actions to the public in a clear and transparent way;
and
• protects its independence by being transparent and credible in pursuit of its goals.
Clearly articulating objectives
Let's consider these four principles, beginning with clearly articulating the objectives of
monetary policy. Congress set our monetary policy goals in the Federal Reserve Act, which
specifies that the Fed "shall maintain long run growth of the monetary and credit aggregates
commensurate with the economy's long run potential to increase production, so as to
promote effectively the goals of maximum employment, stable prices, and moderate
longterm interest rates." Since moderate long-term interest rates generally result when prices are
stable, many have interpreted these goals as a dual mandate to manage fluctuations in
employment in the short run while preserving price stability in the long run.
In my view, this dual mandate has contributed to a view that monetary policy can accomplish
far more than perhaps it is capable of achieving. I believe that assigning multiple objectives
for the central bank has opened the door to highly discretionary policies, which can be
justified by shifting the focus or rationale for action from goal to goal. That is why I have
argued that Congress ought to redefine the Fed's monetary policy goals to focus solely, or at
least primarily, on price stability. I base this on two facts: Monetary policy has a very limited
ability to influence real variables, such as employment. Even the FOMC's own statement of
longer-run goals adopted in 2012 notes that the maximum level of employment is largely
determined by nonmonetary factors, such as changing demographics and changing tax and
regulatory policies that influence the labor market. Conversely, in a regime with fiat currency,
only the central bank can ensure price stability. Indeed, it is the one goal that the central
bank can achieve over the longer run.
Setting clear, achievable objectives is the first part of the framework. Asking policymakers to
pursue those objectives in a systematic, rule-like approach is the second key principle.
The benefits of systematic monetary policy
So, what do I mean by a systematic approach to policy? Quite simply, I mean conducting
policy in a more rule-like manner. You often hear Fed officials say that policy decisions are
"data dependent" and, indeed, they are. This means that future policy actions are conditional
on how the economic data unfold. We may not know what the future holds or what future
policy decisions will be, but we can choose to make those decisions in a systematic way
based on the incoming economic data. I have long advocated this approach to "rule-like"
policymaking.1
Of course, the alternative to rule-like policy is discretionary policy, in which policymakers are
free to choose whatever action seems appropriate or convenient at the time. Rules act as
restrictions on policymakers' choices - limiting the degree of discretion. But this is not a bad
thing; rather, it can result in better economic outcomes in the long run. This is accomplished
in part by reducing the risk of very bad discretionary decisions, such as those that occurred
in the 1970s. Moreover, for more than 30 years, we have known that a credible commitment
by policymakers to behave in a systematic rule-like manner leads to better outcomes than
discretion by reducing policy uncertainty.2
More specifically, rules work better than discretion because they are transparent and
therefore allow for simpler and more effective communication of policy decisions.
This allows households and businesses to more accurately form expectations and thus make
better decisions. As a result, systematic policy promotes a more stable, predictable, and
efficient economy.
I want to emphasize that monetary policy should be data dependent, not date dependent. In
my last vote as a member of the FOMC in December, I dissented, in part because I believe
the language of the statement was still trying to communicate policy in terms of time.
Whether the Committee states that it will be "patient" or that it will wait a "considerable time,"
the language continues to stress the passage of time as a key determinant of policy, rather
than making clear that policy will depend on the data. Describing policy in terms of time could
also risk limiting the Committee's flexibility to respond to the data if we continue to see an
improving economy.
Instead, I believe we should describe how we will respond to the data; that is, we should
describe a reaction function. I frequently consider such reaction functions as I think about
policy. These are typically Taylor-like rules, named for 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 goal 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.
Such robust rules recognize that data are measured imprecisely and are subject to revision.
Moreover, they have been shown to perform well in a variety of models and conditions. I
believe these robust rules can be useful guideposts for policymakers and the public in
assessing the stance of monetary policy and its expected path. Communicating about such
guideposts would enhance transparency and help make policy more systematic.
However, I don't believe that we need to follow rules mechanically. Judgment will always be
required. Yet, policymakers and the public should be very cautious when they call for policy
rates to deviate in significant ways from these guideposts. Making such judgments should
require careful analysis, and the justification for deviating from the guidelines should be
clearly communicated to the markets and to the public. Thus, policymakers will still be able to
exercise discretion, but using rules as guideposts will enhance transparency and effective
communication.
Improving transparency
This leads me to my third important principle for monetary policy - communicating in a clear
and transparent way. In recent speeches, I have proposed that the FOMC could improve
communication and transparency by publishing a more comprehensive monetary policy
report on a regular basis, perhaps quarterly.3
This report could incorporate a discussion of such robust systematic rules I referred to a
moment ago in its description of the underlying policy framework. The rules could serve as a
benchmark for the current stance of policy and the expected path of policy, based on
economic data.
At the end of December, the Philadelphia Fed issued an example of what such a discussion
might look like in a monetary policy report. We used a set of policy rules to benchmark the
current stance and path of policy and discussed the implications.4
The report showed that the federal funds rate is no longer constrained by the zero lower
bound under a number of these rules. In fact, the rules indicate that maintaining the federal
funds rate at the zero lower bound is unusually accommodative by historical standards. The
benchmarks suggest that as the economy transitions to full employment and moves closer to
its long-run inflation target, we should begin to gradually reduce accommodation by raising
the funds rate target. Delaying liftoff runs the risk of requiring more aggressive future
monetary policy than would otherwise be needed.
However, if the Committee felt it was desirable to further delay the initiation of interest rate
increases, such a report would provide the opportunity, indeed the obligation, for a thorough
and thoughtful discussion about why discretionary deviations from the guideposts were
appropriate.
Thus, publishing a monetary policy report with an assessment of the likely near-term path of
policy rates, in conjunction with its economic forecast, would be a useful exercise and
enhance communications. It would also provide added discipline for policymakers to stick to
a systematic, rule-like approach. And it would force policymakers to think more deeply and
systematically about policy and the justification for significant deviations from the guideposts.
Preserving independence
I believe such communication would ultimately strengthen the independence of the central
bank, which is the fourth and final principle of sound central banking. Central bank
independence leads to better economic outcomes. But in a democratic society,
independence must be accompanied by accountability.
Transparent and clear communication of monetary policy goals and a decision-making
framework help ensure accountability and preserve central bank independence.
Transparency can also enhance a central bank's credibility. A central bank that is transparent
will be less willing to make promises it cannot keep. And accountability is more easily
achieved when there is transparency. The public can best hold a central bank accountable
when its goals are clearly stated and achievable. Broad, ill-defined goals, on the other hand,
reduce accountability and invite discretionary policies that can undermine the public trust and
thus jeopardize independence. This is one reason why I have been concerned about credit
allocation initiatives by the Fed that treated some creditors more favorably than others in
bailouts and that sought to provide special support to the housing sector through its
purchases of mortgage-backed securities. Such credit allocation decisions more
appropriately rest with the fiscal authorities, not the central bank. By pushing these
boundaries, the Fed puts its independence at risk.
Conclusion
In conclusion, the U.S. economy continues to improve. Although we have not witnessed the
strong bounce back from the depths of the recession that some anticipated, the recovery has
been remarkably steady.
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
households have regained much of the wealth they lost during the crisis. That gives me
additional confidence that the economy is now operating normally and so should monetary
policy.
As we normalize policy, I believe we should follow four principles. The Fed should ensure
that it has clearly articulated objectives that can be achieved by monetary policy, with price
stability as the primary objective. It should pursue its objectives in a systematic, rule-like
manner and help the public understand how policy will react systematically to changes in
economic conditions.
I believe a detailed monetary policy report could be a useful vehicle for such enhanced
communication of policy, which will improve the transparency and predictability of monetary
policy, which ultimately reduces policy surprises. Businesses and consumers are more
informed about the course of monetary policy because they understand how policymakers
are likely to react to changing economic circumstances, even if they are not certain what
those economic conditions might be.
Equally important in my view is that greater clarity about policymakers' reaction function
strengthens accountability. So, systematic policy, communicated transparently, strengthens
accountability and credibility and, thus, serves to preserve the central bank's independence.