Charles I Plosser: Perspectives on the economy and monetary policy
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at The School of Business at La Salle University, Union
League of Philadelphia Business Network, Philadelphia, Pennsylvania, 14 January 2014.
* * *
The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC.
Introduction
I want to thank La Salle University and the Union League for inviting me to speak at this
annual economic event. The new year always seems like a good time to reflect on the past
and refresh our outlook for the future, and I will try to do a bit of both today.
This is a particularly noteworthy time in the history of the Federal Reserve. On December 23,
1913, President Woodrow Wilson signed into law the act that created the Federal Reserve
System. Thus, the Fed's official 100th anniversary occurred just three weeks ago.
So, I thought I would begin by sharing a brief history of our nation's central bank with you
before discussing my views on economic conditions and monetary policy.
Before I begin, though, I should note that my views are not necessarily those of the Federal
Reserve System or my colleagues on the Federal Open Market Committee (FOMC).
A historical look at a decentralized Fed
What better place to share a little history of our central bank than here in Philadelphia and in
this historic venue of the Union League. Just a few blocks from where the Philadelphia Fed
stands on Independence Mall, you will find vestiges of two earlier attempts to create a central
bank for the United States, dating back to the time Philadelphia was the nation's major
financial and political center.
The first institution was the brainchild of our first Treasury secretary, Alexander Hamilton. His
efforts led to the creation of the First Bank of the United States, which was awarded a
20-year charter by Congress in 1791.
Although the First Bank's charter was not renewed, the War of 1812 and the ensuing inflation
and economic turmoil convinced Congress to establish the Second Bank of the United
States. It was also given a 20-year charter and operated from 1816 to 1836. However, its
charter was not renewed - Congress could not override the veto of President Andrew
Jackson, who led the opposition to the central bank. Public distrust of centralized power was
an important factor in the demise of both banks. Both became entangled in politics, and both
failed to gain the public's confidence and establish the independence necessary to serve our
vast and diverse country of bakers and bankers, farmers and financiers, and manufacturers
and merchants.
It took Congress nearly 80 years to try again to establish a central bank. This time Congress
and President Wilson agreed upon a uniquely American governance structure - a
decentralized, central bank.
To balance political, economic, and geographic interests, Congress created the Federal
Reserve System made up of regional Reserve Banks with oversight provided by a Board of
Governors in Washington, D.C.
This structure helped to overcome political and public opposition stemming from fears that a
central bank would be dominated either by political interests in Washington or by financial
interests on Wall Street.
The Federal Reserve Act formed a Reserve Bank Organization Committee to divide the
country into no fewer than eight and no more than 12 Federal Reserve Districts.
Almost immediately after the law was enacted, the committee started receiving letters and
telegrams from local business owners, bankers, farmers, and others, who were all making a
case for where they wanted a Reserve Bank to be located.
The committee held meetings in 18 cities before submitting a report to Congress in April
1914, naming the final 12 cities and districts. The Federal Reserve Bank of Philadelphia was
designated as the regional Reserve Bank for the Third District, an area that includes
Delaware, the eastern two-thirds of Pennsylvania, and the southern half of New Jersey.
These Reserve Banks distribute currency, act as a bankers' bank, and generally perform the
functions of a central bank, which includes serving as the bank for the U.S. Treasury.
The 12 regional Reserve Banks are deeply rooted in our nation's communities, which ensure
that the Federal Reserve stays in touch with Main Street. The Reserve Banks all have
boards of directors, many also have Branch boards, and all have advisory councils and other
mechanisms to keep abreast of conditions in their regional economies. This rich array of
information and the diverse views from around the country contribute to a mosaic of the
economy that is essential as we formulate national monetary policy.
Of course, most people associate the Fed with the determination of monetary policy. Within
the Federal Reserve, the body that makes monetary policy decisions is the Federal Open
Market Committee, or the FOMC. Here again, Congress has designed the system with a
number of checks and balances. Since 1935, the composition of the FOMC has included the
seven Governors in Washington, the president of the New York Fed, and the presidents of
four other Reserve Banks who serve one-year terms as members on a rotating basis.
One important role of the independent regional Reserve Banks is to ensure that diverse
views are represented. The Reserve Banks each have economic research departments to
guarantee that a wide variety of perspectives are brought to the table. In this way, the
institution avoids groupthink. By being open and transparent about these various
perspectives, the decentralized model for the Federal Reserve helps strengthen public
confidence and preserve its independence.
Whether we vote or not, all Reserve Bank presidents attend the FOMC meetings, participate
in the discussions, and contribute to the Committee's assessment of the economy and policy
options. The FOMC has eight regularly scheduled meetings a year to set monetary policy. It
discusses economic conditions and, in normal times, adjusts short-term interest rates to
achieve the goals of monetary policy that Congress has set for us in the Federal Reserve
Act.
Congress established the current set of monetary policy goals in 1978. The amended
Federal Reserve Act specifies that the FOMC "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 long-term interest rates." Since moderate long-term interest rates
generally result when prices are stable and the economy is operating at full employment,
many have interpreted these instructions as being a dual mandate to manage fluctuations in
employment in the short run while preserving price stability in the long run.
Economic conditions
In order to determine the appropriate monetary policy to promote these goals, the FOMC
must monitor economic developments. So, let me turn to an assessment of our economy. As
we enter 2014, I think the bottom line is that the economy is on firmer footing than it has
been for the past several years.
Real output grew at a 4.1 percent annual pace in the third quarter of last year, the strongest
gain in nearly two years and a marked acceleration from the first half of 2013. Some of this
growth came in the form of inventory investment, which is volatile and is less likely to have
contributed as much to growth in the fourth quarter. Still, personal consumption and fixed
investment provided positive contributions, and economic prospects at the end of last year
and the beginning of this year are positive.
Personal consumption, which accounts more than two-thirds of GDP, advanced at an annual
rate of 2 percent in the third quarter. Some observers have lamented at the lack of stronger
growth in consumption. But I would note that consumption growth has not fluctuated that
much over the course of the recovery. I am encouraged by the U.S. consumers' persistence
in the face of many challenges, including a payroll tax hike last January, a government
shutdown, significant uncertainties about future tax policy, and the implications of health-care
reform.
Consistent job growth has added to wage and salary growth, which has supported spending.
The December employment report released last Friday, which showed payroll gains of
74,000 jobs, came in below many analysts' expectations. Yet, I caution you not to read too
much into one month's number. December's number was likely affected by the unseasonably
cold and snowy weather, although it is not yet clear by how much. The number is also
subject to revision, and such revisions can be significant.
Because of the month-to-month volatility and data revisions, I prefer not to read too much
into the most recent number but, instead, look at averages over several months, and here
the news remains positive. Firms added an average of 182,000 jobs per month last year,
comparable to the pace in 2012. This consistent pace of job growth was enough to drop the
unemployment rate to 6.7 percent in December. This means that the unemployment rate fell
1.2 percentage points last year, and, importantly, it is at a lower level than the FOMC
anticipated it would be at this point when we started the current asset purchase program in
September 2012. That is, the labor market has performed noticeably better than expected,
according to the unemployment rate measure.
Some people, however, feel that the decline in the unemployment rate overstates the degree
of progress being made in labor markets because it reflects declines in labor force
participation as well as increases in employment. There is even concern that the
unemployment rate will move back up significantly when discouraged workers reenter the
labor force. Based on research by my staff, I am less concerned about this possibility.1
First, it is important to realize that labor force participation rates have been declining since
2000. The declines are driven mostly by demographic changes, including the aging of the
baby boomers. This trend is ongoing and was expected to accelerate.
Second, detailed analysis of the Current Population Survey's micro data indicates that much
of the decline in participation since the start of the recovery can be accounted for by
increased retirements and disability. Some of these increases might have been driven by the
state of the economy as some baby boomers perhaps moved their retirement decision
forward after losing a job. Nevertheless, few of these former individuals are likely to reenter
the labor force. In addition, there has been an increase in the number of people out of the
workforce who are going to school, which means there is less concern about skill
depreciation for these people. So while I do expect some discouraged workers to reenter the
labor force as the expansion picks up and while they search for a job there could be upward
pressure on the unemployment rate, I would not overinterpret the decline in participation as a
lack of progress made in labor market conditions or as a problem that must be corrected.
There are fundamental changes in the structure of the labor market that are likely real and
sustained.
The progress in the labor market has led to growth in household income. In addition to
income growth, household balance sheets have strengthened as well. Overall household
wealth, in nominal terms, advanced 11 percent year over year through the third quarter. The
improving housing market has been an important contributor to that growth, with owners'
equity in real estate surging 29 percent in 2013 over 2012. House prices are rising; the
number of homeowners with underwater mortgages and the number of mortgage
delinquencies are down. I expect these improvements will help to support consumer
spending going forward.
Business balance sheets are also healthy. Industrial production was very encouraging in
November, when it advanced 1.1 percent on gains in all major categories. That growth was
the most rapid in 12 months and brought the overall index higher than its prerecession peak
for the first time. The Philadelphia Fed's Business Outlook Survey of regional manufacturing,
which is a reliable indicator of national manufacturing trends, has also been in positive
territory for seven months, and our firms expect continued expansion in manufacturing
activity over the next six months. This gives me some hope that business fixed investment,
which has been generally lackluster during the course of the recovery, will pick up somewhat
this year.
Inflation has been running below the FOMC's long-run goal of 2 percent. The year-over-year
change in the price index for personal consumption expenditures, or PCE inflation, is the
Fed's preferred measure. It has drifted downward over the past year to about 0.9 percent in
November. Core PCE, a measure that removes food and energy prices that tend to be
volatile, was a bit higher at 1.1 percent. I believe we must defend our 2-percent inflation
target from below and above. However, I believe inflation is likely to firm up as some of the
factors that have held it down, such as the cut in payments to Medicare providers and
generally weak medical costs, are likely to abate over time. I am encouraged that inflation
expectations remain near their longer-term averages and consistent with our 2-percent
target. So, I anticipate, as the FOMC indicated in its most recent statement, that inflation will
move back toward our target over time. Indeed, given the large amount of monetary
accommodation we have added and continue to add to the economy, I think that there is
some upside risk to inflation in the longer term.
I anticipate overall economic growth of around 3 percent this year, a pace that is slightly
above trend. This is far from the robust growth that many would like to see; nevertheless, it
does represent steady progress and an improving economy. My forecast is largely in line
with those of my colleagues on the FOMC, whose most recent projections had a central
tendency of growth of 2.2 to 2.3 percent for 2013, and accelerating to 2.8 to 3.2 percent in
2014.
I believe this growth will continue to lead to declines in the unemployment rate over the next
year and should result in an unemployment rate of about 6.2 percent by the end of 2014.
This makes me somewhat more optimistic than most of my FOMC colleagues, who reported
a central tendency of 6.3 to 6.6 percent by the end of 2014.
Monetary policy
So, let me turn to some observations about monetary policy. Over the past five years, the
Federal Reserve has taken extraordinary 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, or quantitative
easing. We are now in our third round of these purchases, or QE3. These purchases have
greatly expanded the size and lengthened the maturity of the assets on the Fed's balance
sheet.
The Fed is also 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 its December
statement, the FOMC indicated that it intends to leave the policy rate near zero well past the
time that the unemployment rate falls below 6.5 percent, especially if projected inflation
continues to run below the FOMC's 2-percent target.
On asset purchases, the FOMC has indicated that it will continue the purchases until the
outlook for the labor market has improved substantially in the context of price stability. The
Fed has structured its latest round of asset purchases as a flow-based program, with the
idea that policymakers could fine-tune the rate of purchases in response to the economy.
The FOMC decided in December to reduce the purchases from $85 billion to $75 billion per
month. Thus, we are still adding monetary accommodation but at a slightly slower pace.
Asset purchases are not on a preset course and will continue to be contingent on the
FOMC's economic outlook. However, the FOMC did indicate in December that if economic
conditions evolve as expected, with improved labor market conditions and inflation moving
back toward its goal, then the FOMC will likely reduce the pace of asset purchases in
measured steps at future meetings. Chairman Ben Bernanke indicated in his December
press conference that if we are making progress in terms of inflation and continued job gains,
then the program would be concluded late in 2014. The December employment report has
not changed my belief that the economy has already met the criteria of substantial
improvement in labor market conditions. So my preference would be that we conclude the
purchases sooner than this, but I am glad that we have taken the first step on the path to
ending the program.
Eventually, monetary policy will be normalized, but the way in which that is done will depend
on what operating framework we plan to use in the normalized environment. I believe that the
exit strategy principles laid out by the FOMC in June 2011 still apply. More specifically, we
need to return to an operating framework in which a market interest rate is our policy
instrument. We also should shrink the size of our balance sheet, which is now about
$4 trillion, and return to an all-Treasuries portfolio as part of the normalization process.
This sounds easy in principle, but I believe the size and composition of our balance sheet will
make it challenging to execute smoothly.
There are now more than $2.4 trillion of excess reserves in the banking system. These
reserves are not inflationary until they are converted to money and flow out into the
economy.
But as market rates rise in an improving economy, banks will find it advantageous to begin to
increase lending or acquire assets using their reserves. The challenge for the Fed is to
control the flow of reserves so that we can successfully maintain our 2-percent inflation
target. This may require raising interest rates more quickly than currently anticipated. We
have the tools that would enable us to raise rates if we chose to do so. However, the Fed
may be subject to political pressures or pushback from various interest-sensitive sectors that
could result in a more measured response than required.
One of the consequences would be higher inflation. History suggests that the Fed tends to
be behind the curve when it comes time to tighten monetary policy, and in the current
environment, that delay could prove to be more costly than when reserves are in limited
supply. Thus, it's a matter of our will rather than our ability.
Conclusion
In summary, I believe that the 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 gradually, and I expect the unemployment rate will continue its decline to
6.2 percent 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, the reduction in asset purchases from $85 billion a month to $75 billion
a month is a step in the right direction. I believe the economy has met the criteria of
significant improvement in labor market conditions for ending the program and that further
increases in the balance sheet are unlikely to provide appreciable benefits for recovery. Even
after the asset purchase program has ended, monetary policy will still be highly
accommodative.
The work of the Fed, however, is far from over. Monetary policy still faces considerable
challenges as we seek to normalize policy. The task should be to return to a framework in
which a market rate is our primary policy tool, to reduce the size of our balance sheet, and to
restore our portfolio to all Treasuries. The challenge will be to do so 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.