Charles I Plosser: Outlook and a perspective on monetary policy
Text of the Farash Distinguished Lecture by Mr Charles I Plosser, President and Chief
Executive Officer of the Federal Reserve Bank of Philadelphia, at the Zell/Lurie Real Estate
Center Fall Members' Meeting, Wharton, 12 October 2011.
* * *
Good afternoon. Thank you for the opportunity to be here at the Zell/Lurie Real Estate Center
Fall Members' Meeting. Your founding director, Peter Linneman, and I were graduate
students together at the University of Chicago - a long time ago - and so I am especially
delighted to be part of your program today.
I am also honored to have the opportunity to deliver the Farash Distinguished Lecture. Max
Farash, who died last year at age 95, was a Rochester-based real estate pioneer, and I had
the honor of knowing Max over the years, especially when I served as dean of the Simon
School of Business at the University of Rochester.
Today, I'd like to share with you some thoughts on the nation's economy. I will also discuss
my views on monetary policy. As always, these are my views and do not necessarily
represent the views of the Federal Reserve Board or my colleagues on the Federal Open
Market Committee.
Economic outlook
The U.S. economy has not lived up to expectations this year. Indeed, in July we learned from
the revisions to the government's economic data that the recession was deeper and the
recovery was weaker than we had previously thought. Some of this weakness is perfectly
understandable, given the unanticipated shocks we experienced. We began the year with
severe snowstorms in the East, then the earthquake and ensuing disasters in Japan,
followed by the unrest in the Middle East and North Africa that led to a run-up in oil prices,
and a renewed concern about European sovereign debt. And all of that occurred before May.
Over the summer, the economy faced more challenges, with the further deterioration of the
European sovereign debt crisis, as well as our own fracas in Washington over fiscal policy
and the debt ceiling. These events weighed heavily on business and consumer confidence.
While many of these factors are transitory, and each will wane in time, the cumulative effect
has served to feed uncertainty and inhibit growth.
Indeed, growth in the first half of 2011 was less than 1 percent, reflecting a very weak first
quarter, and while the second quarter improved, growth remained well below the longer-term
trend. In light of this performance, most forecasters have revised down their forecasts for
overall growth for the full year. I now expect GDP growth to be less than 2 percent in 2011,
with an acceleration to around 3 percent in 2012.
Although the downside risks around this forecast are apparent, I do not believe we are on the
verge of a double-dip recession. Indeed, many of my business contacts suggest that while
growth is very sluggish and uneven, they do not see the precipitous declines that many news
accounts would suggest. Perhaps the greatest uncertainty today surrounds the outcome of
financial events in Europe. The sovereign debt crisis is not resolved. Financial markets seem
very sensitive to news from Europe, even to the point of discounting positive news on the
U.S. economy. Resolution or greater clarity on the path forward in Europe would be most
helpful for the U.S. and world economic growth prospects.
Yet as our economy recovers, we must realize the financial crisis was a severe shock that
affected many economies around the world and led to a recession of great depth and
structural imbalances. Prior to the recession, some sectors, such as financial services and
real estate, had grown to historically high shares of U.S. GDP. As the economy rebalances,
they may not return to those pre-recession highs, nor should we necessarily seek or expect
them to do so.
Consumer and business spending
Now, let me turn to consumer and business spending. One of the more striking aspects of
this recession is the continued weakness in consumer spending relative to previous
recoveries. There were modest increases last year, but spending decelerated over the first
half of this year in the face of higher oil prices and the continued deleveraging of household
balance sheets. Consumers continue to pay down debt and work to rebuild their net worth by
saving more and consuming less. This is a perfectly natural and rational reaction to events.
Until these households perceive that they have restored a balance to their long-run
consumption and saving patterns commensurate with their earnings prospects, they will
remain conservative in their spending patterns. Moreover, the more uncertain they are about
their own future earning power, the more reluctant households will be to spend and the more
they will feel the need to save to protect their families against unforeseen events.
A brighter spot has been business investment spending, which has been supported by solid
growth in corporate earnings. Looking beyond the month-to-month volatility, spending on
equipment and software has continued to expand. The new orders data suggest continued
growth, although perhaps not at the same pace. Indications from some of the regional
business surveys, like the Philadelphia Fed's Business Outlook Survey of manufacturers,
suggest some weakness relative to earlier in the year.
Many commentators have taken note of the weakness in our monthly survey, since it has
proven to be a useful gauge for national trends in manufacturing. In August and September,
the measures of current activity were negative. But our polling in August took place in the
midst of market volatility after Standard & Poor's downgrade of U.S. debt, and the September
survey occurred just days after the hurricanes and the severe flooding in New Jersey and
Pennsylvania. Measures of future activity, however, have remained positive, and September
was stronger than August, suggesting that firms expect activity to pick up over the next six
months.
Nevertheless, the volatility in the financial markets over the last few months has contributed
to sharp declines in business and consumer sentiment. With many businesses and
consumers uncertain about future taxes, regulations, and the financial ramifications of the
European sovereign debt situation, it is no wonder that sentiment is flagging. This high
degree of uncertainty dampens current growth and poses added risk to the forecast.
Labor markets
Conditions in labor markets remain a serious challenge. Given the weak growth in
employment so far this year, we have not made even the modest progress on reducing
unemployment rates that many forecasters had anticipated. The September employment
report, including revisions to July and August, was a bit of positive news. Firms added
287,000 jobs to their payrolls in the third quarter, comparable to the second quarter. But this
pace is below what is needed to make significant progress in reducing the unemployment
rate, which has remained stubbornly high at 9.1 percent.
The challenges facing the employment situation are underscored by the fact that more than
40 percent of the unemployed, or some 6 million people, have been out of work for 27 weeks
or longer. This suggests we should not expect an easy solution to the problems in the labor
market. Millions of unemployed workers may take longer to find jobs because their skills
have depreciated, or they may need to seek employment in other sectors or in other parts of
the country. These sorts of adjustments will take time to resolve. Jobs and workers will need
to be reallocated across the economy and across the country, which is likely to be a long and
slow process.
Thus, while I expect a moderate recovery to continue and to strengthen over time, I expect to
see only modest declines in the unemployment rate, with probably little change over the rest
of this year, and then gradually falling to a range of 8 to 81⁄2 percent by the end of 2012.
Inflation
Let me now turn to my outlook for inflation. Just as growth has been weaker this year than
many forecasters had anticipated, inflation has been higher than expected. Monthly changes
in inflation have moderated slightly from those seen earlier in the year as the prices of oil and
other commodities have come down. However, measured on a year-over-year basis, both
total inflation and core inflation continue to advance. I do anticipate that with many
commodity prices now leveling off or falling, and inflation expectations relatively stable,
inflation will moderate in the near term.
Our focus should not be so much on the near term as on the medium term. Looking further
ahead, we must continue to monitor this situation very carefully, particularly in this
environment of very accommodative monetary policy. Inflation most often develops
gradually, and if monetary policy waits too long to respond, it can be very costly to correct.
Indeed, it is good to remember that the current inflationary environment is quite different from
the one we faced a year ago when we embarked on the so-called QE2 policy to purchase
$600 billion of long-term U.S. Treasuries. At the time, inflation was falling and there were
concerns about deflation - year over year, PCE inflation was running about 1.2 percent and
core PCE inflation (excluding food and energy) was under 1 percent. Today, PCE inflation is
2.9 percent and core PCE is running nearly 1.7 percent. I would also note that
unemployment was 9.8 percent last fall compared to 9.1 percent today. Thus, with inflation
higher and unemployment lower, it is not so surprising that some might question the need for
the additional accommodation the FOMC undertook in August and September - a point I will
return to shortly.
In this environment, I think it is very important that we refrain from actions that risk fueling a
steady rise in inflation or inflation expectations over the medium term. We must not become
too sanguine that high unemployment will lead to low inflation. The lesson of the 1970s is
clear - high unemployment or low resource utilization is not sufficient to prevent high rates of
inflation. The current environment in the United Kingdom should also be a warning. The
unemployment rate in Britain is near 8 percent, having risen sharply during its recession, yet
inflation is now approaching 5 percent and has been steadily rising for nearly two years.
Monetary policy
This brings me to a discussion of the recent policy actions the Fed has taken, why I
dissented from these actions in August and September, and what I believe should be the
long-term framework of monetary policy.
As I noted at the beginning of my remarks, the economic conditions of the past few years
have led to extraordinary monetary policy accommodation. To date, our actions have kept
the federal funds rate - the traditional instrument of monetary policy - near zero for almost
three years. The Fed's balance sheet has grown more than threefold, from nearly
$900 billion before the crisis to about $2.9 trillion today. Moreover, the asset composition has
shifted significantly from mostly short-term Treasuries to longer-term Treasuries,
mortgagebacked securities, and agency debt. This extraordinary degree of monetary accommodation
has played a role in supporting the recovery thus far, and it continues to do so.
In August, the FOMC changed its guidance about its expectations for the future path of the
federal funds rate. In particular, it stated that economic conditions were "likely to warrant
exceptionally low levels for the federal funds rate at least through mid-2013." At its late
September meeting, the FOMC announced additional accommodative action. In an effort to
reduce long-term Treasury yields from already historically low levels, the FOMC intends to
purchase $400 billion of longer-term Treasury securities and to sell an equal amount of
shorter-term Treasuries by the end of June 2012. This action will not increase the size of the
Fed's balance sheet, but it will lengthen the maturity of the Fed's holdings. In addition, the
FOMC will be reinvesting principal payments from its holdings of agency debt and agency
mortgage-backed securities in mortgage-backed securities rather than Treasuries. This
action was intended to help support mortgage markets.
I dissented from both of these decisions. As I noted earlier, given that inflation was notably
higher and unemployment lower than it was last fall when we embarked on our second round
of asset purchases, it wasn't clear that further accommodation was called for. In addition, I
believe these actions will do little to improve the near-term prospects for economic growth or
employment, but they do pose some real risks. Policy actions are not free and should be
evaluated based on the costs and benefits.
Based on our experience with Operation Twist in the 1960s and with last year's QE2, the
reduction in long-term rates from our actions in September is likely to be less than 20 basis
points for the 10-year Treasury yield, which is currently only 2 percent. The pass-through to
the rates at which consumers and businesses actually borrow is likely to be considerably
less. Thus, I am skeptical that this will do much to spur businesses to hire or consumers to
spend, given the ongoing adjustments occurring in the economy and the uncertainties posed
by the fiscal challenges both here and abroad.
In addition to having little benefit, the actions come with significant potential costs. We have
provided a great deal of monetary accommodation to the economy, and given the
stubbornness of the unemployment rate in responding to these efforts, we should be
cautious and vigilant that our accommodative policies do not translate into a steady rise in
inflation over the medium term even while the unemployment rate remains elevated. Creating
an environment of stagflation, reminiscent of the 1970s, will not help businesses, the
unemployed, or the consumer. It is an outcome we must carefully guard against.
We also need to ensure that Fed policy remains credible. Economic theory and historical
experience tell us that a central bank's ability to maintain price stability and promote
economic growth hinges on its credibility. Actions that undermine credibility can put at risk
the effectiveness of a central bank's ability to achieve its objectives. In my view, the actions
taken in August and September risk undermining the Fed's credibility by giving the
impression that we think such policies can have a major impact on the speed of the recovery.
It is my assessment that they will not. We should not take actions simply because we can. To
address our economic ills we must apply the appropriate remedies. A doctor who
misdiagnoses a disease and prescribes the wrong medicine can make the patient worse.
The ills we currently face are not readily resolved through ever more accommodative
monetary policy. If we act as if the Fed has the ability to solve all our economic problems, our
credibility will be undermined. The loss of that credibility and the loss of the public's
confidence could be costly to the economy because it will make it much harder for the Fed to
implement effective monetary policy in the future.
Credibility was also at the center of my opposition to changing the forward policy guidance in
August. I was concerned that tying monetary policy to the calendar could be misinterpreted
by the public; it could suggest that monetary policy is no longer contingent on how the
economic outlook evolves. This could lead to a loss of credibility should economic conditions
develop in a way that requires the federal funds rate to be adjusted prior to mid-2013. And in
my view, given the outlook, economic conditions will likely warrant that the Fed begin to raise
rates before then. If such a move is required and we don't act, our credibility to control
inflation would be severely damaged. Yet, if we do act, our credibility will also be damaged
because we encouraged the public to believe we would not act before mid-2013.
Finally, the actions taken at our last meeting will make our exit from this period of
extraordinary accommodation more complicated. Since we will have more long-term
Treasury securities and mortgage-backed securities in our portfolio, the time it will take to
unwind and get back to our stated goal of returning to an all-Treasuries portfolio and
shrinking our balance sheet may need to be extended and may put at risk our ability to
control inflation over the medium term.
This does not mean that I see no circumstances in which further monetary policy action
should be taken. Should the developments in the euro area lead to significant financial
market disruptions, the Fed would need to respond in its role of lender of last resort to
support financial stability and the payments system. Or if deflationary fears were to become a
real threat again and we saw signs that the economy was moving to a sustained disinflation
with declining inflation rates and inflation expectations, then we would need to consider
further action to stabilize inflation expectations.
The past three years have proven to be challenging times for monetary policymakers both
here and abroad. We are in unprecedented territory in terms of policy tools and actions
employed. This creates difficulties not only for policymaking but also for the Fed's
communications. In my view, a high priority for the Fed must be to strengthen our monetary
policy framework and articulate that framework to the public so that they will better
understand the basis for our decisions and be better able to formulate expectations of future
policy actions.
I believe that this communication, and our accountability to the public, could be greatly
enhanced were the Fed to adopt an explicit numerical inflation goal. For nearly 20 years, I
have advocated that the Fed make explicit its commitment to a numerical inflation objective
in support of its full mandate. I believe that now is an opportune time to do so.
Having such an objective in place would prove particularly useful in the current environment
in which the Fed is providing monetary stimulus using new tools that are not as familiar to the
public and when some may view the fiscal situation as threatening the independence of the
Federal Reserve and its ability to maintain price stability. And it will help in the future by
keeping inflation expectations well anchored during the eventual exit from these
extraordinarily accommodative measures.
Conclusion
In summary, the U.S. economic recovery will continue and gradually strengthen over time. I
expect annual growth of less than 2 percent this year to gradually accelerate to around
3 percent next year. As the economy strengthens, prospects for labor markets will continue
to improve and the unemployment rate will gradually decline, undoubtedly too gradually for
many of us.
As we move forward in this time of change, the Federal Reserve remains committed to its
long-run statutory goals of price stability and maximum employment. And it is a credible
commitment to price stability that provides the surest path for monetary policy to successfully
promote economic growth and employment.