Charles I Plosser: Economic outlook
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at the Business Leaders Forum, Villanova School of
Business, of Philadelphia, Pennsylvania, 29 September 2011.
* * *
The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC.
Good morning. Thank you for the opportunity to be here at the Villanova School of Business
to address this second annual Business Leaders Forum.
As leaders engaged in our business community, you are all aware of the painfully protracted
pace of our economic recovery. I have been saying for quite some time that this was going to
be a long, slow recovery. Moreover, this frustrating state of affairs continues despite
extraordinarily accommodative monetary policy.
In my remarks today, I will discuss my outlook for the U.S. economy, as well as my views on
the appropriate current and future monetary policy. As always, my remarks reflect my own
views and do not necessarily represent the views of the Federal Reserve Board or my
colleagues on the Federal Open Market Committee.
Economic outlook
Let me begin with an update on the U.S. economy. Clearly, this year has not played out as
almost anyone forecasted. Indeed, from the revisions to the government's economic data in
July, we now know that the recession was deeper and the recovery was weaker than we had
previously thought. Some of this year's weakness is understandable. 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 and the run-up in oil prices, and a
lingering concern about sovereign debt in Europe. And all of that occurred before May.
With the arrival of summer, we faced another round of problems with the worsening of the
European sovereign debt crisis, as well as our own fracas on fiscal policy and the debt
ceiling debates in Washington. These events all weighed heavily on business and consumer
confidence.
While many of these factors are transitory, and each will wane eventually, the cumulative
effect has served to feed uncertainty and inhibit growth.
Indeed, growth in the first half of 2011 was much weaker than anticipated. In light of this
performance most forecasters have revised down their forecasts for overall growth in 2011.
Indeed, at the beginning of the year, I was expecting GDP growth in 2011 to be 3 to
3.5 percent. Now, I expect GDP growth to be less than 2 percent in 2011, but to gradually
accelerate to around 3 percent in 2012.
Although the downside risks around this forecast are significant, I do not believe the current
data signal that we are on the precipice of a so-called 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 the news headlines suggest.
Instead, their stories are consistent with a slow recovery due to the very nature of the
recession from which we have emerged. The financial crisis was a severe shock that
impacted many economies around the world and led to a recession of great depth and
structural imbalances. Some sectors, such as financial services and construction, may never
return to their pre-recession shares of our economy. The aftermath of the financial stress and
the weak housing sector will weigh on the pace of recovery for some time to come.
Consumer and business spending
One of the more striking aspects of this recession is the continued weakness in consumer
spending. While there were modest increases last year, spending decelerated notably over
the first half of the year. Partly this reflects the effect of higher oil prices we saw earlier in the
year. Partly it reflects the continued deleveraging of the household balance sheet, as
consumers pay down debt and work to rebuild their net worth. Most observers agree that
weak income growth and falling house prices are restraining spending and we are unlikely to
see strong consumer spending as long as we face a depressed housing market and a weak
labor market.
Another way to view weak consumption is to note that households are continuing to
restructure their balance sheets - 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 profile, they will not increase spending. Moreover, the more uncertain they are
about their own earning power, the more reluctant households will be to increase spending
and the more they will feel the need to build up their savings.
A brighter spot has been business investment spending, which has been supported by solid
growth in corporate earnings. Looking through the month-to-month volatility, spending on
equipment and software has continued to expand.
Indicators from business surveys, including the Philadelphia Fed's Business Outlook Survey
of manufacturers, suggest some weakening in conditions, although it is too soon to tell
whether this will be persistent.
Many 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 coincided with market volatility in
the aftermath of Standard & Poor's downgrade of U.S. debt. Measures of future activity have
remained positive, and September was stronger than August, suggesting that firms expect
activity to pick up over the next six months.
Recent volatility in financial markets has contributed to sharp declines in business and
consumer sentiment. But with a high degree of uncertainty over future taxes, regulations, and
the financial ramifications of the European sovereign debt situation, it is no wonder that
sentiment is flagging and this decline poses added risk to the growth forecast.
Labor markets
Conditions in labor markets remain a serious challenge. Given the weak growth so far this
year, we have not made even the modest progress on reducing unemployment rates that
forecasters anticipated. Most recently, nonfarm payroll employment was flat in August, and
the unemployment rate remained at 9.1 percent. Private payrolls added just 17,000 jobs, far
below what we will need to see just to keep pace with changes in the labor force. Ongoing
budget pressures faced by state and local governments have led to cuts in public payrolls.
These numbers are troubling, especially when more than 40 percent of the unemployed, or
some 6 million people, have been out of work for 27 weeks or longer. This underscores that
we should not expect any easy solution. 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. These structural issues will take time to resolve. Jobs and workers will need to
be reallocated across the economy, which is 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 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 when the prices of
many commodities, including oil, were rising sharply. However, measured on a
year-overyear 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.
However, we must continue to monitor this situation, particularly in this environment of very
accommodative monetary policy. 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, there
were concerns about deflation, whereas now inflation is running above our long-run goal. I
would also note that unemployment was higher last fall than it is today. Thus, with inflation
higher and unemployment lower, it is appropriate to ask what criteria we are using to justify
further accommodation. 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 U.K. 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 view 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 led to a
level of the federal funds rate - the traditional instrument of monetary policy - that has been
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, and its asset composition
has shifted significantly from mostly short- to medium-term Treasuries to longer-term
Treasuries, mortgage-backed 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 meeting
last week, 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 these decisions because I believe that they will do little to improve the
nearterm prospects for economic growth or employment and they do pose risks. Policy actions
should never be considered 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 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 much less. Thus, I am skeptical that this will do
much to spur businesses to hire or consumers to spend, given the ongoing structural
adjustments occurring in the economy and the uncertainties posed by the fiscal challenges
both here and abroad.
In addition to having little effect, 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 previous 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. In my view, the actions taken in
August and September tend to undermine 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 certain 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, the
credibility of the institution is undermined. The loss of that credibility and 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 calendar time could be misinterpreted
by the public as suggesting that monetary policy is no longer contingent on how the
economic outlook evolves. This could also lead to a loss of credibility should economic
conditions develop in a way that requires the federal funds rate to be adjusted prior to
mid2013. And in my view, given the outlook, economic conditions will likely warrant that the Fed
begin to raise rates before that time.
Finally, the actions taken at our last meeting will make our exit from this period of
extraordinary accommodation more complicated. We will have more long-term Treasury
securities and more mortgage-backed securities in our portfolio, which may extend the time it
will take to withdraw from allocating credit to particular sectors of the economy and return to
our stated goal of an all-Treasuries portfolio.
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. I do not see either of these scenarios in my
forecast, so I do not anticipate that further accommodative monetary policy actions will need
to be taken.
An explicit numerical objective for inflation
The past three years have proven to be challenging times for monetary policymakers. We
entered unprecedented territory as we employed new policy tools to stem the financial crisis
and limit the damage to the economy from the severe economic recession. There was no
established framework for making policy decisions in such an environment, and that added to
the difficulties in determining appropriate policy. It also created difficulties 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.
An important first step in that direction is for the Federal Reserve to adopt an explicit
numerical objective for inflation. The explicit inflation goal would help to anchor inflation
expectations, raise policy transparency, and increase the central bank's accountability for its
actions. There is considerable evidence that countries that have adopted such an objective
as a cornerstone of their monetary policy decision-making have had more success at
achieving price stability without any deterioration in the stability of real activity. In the United
States, Congress has given the Fed a mandate to promote the goals of maximum
employment, stable prices, and moderate long-term interest rates. Price stability is the most
effective way for monetary policy to promote the other two goals. Thus, by helping the Fed
achieve and maintain price stability, an explicit inflation objective would help the Fed promote
all three of the goals set forth by Congress.
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.
First, it will increase the credibility of our commitment to keeping prices stable even as we
employ new, less familiar policy tools.
Second, we are confronting an environment where some may be questioning the ability or
resolve of the government to address our long-run fiscal problems. In such an atmosphere of
uncertainty, being explicit about our inflation goal will underscore the Fed's commitment not
to succumb to external pressures to use inflation as a solution to the country's long-run
deficit problem. This will help anchor inflation expectations, which is critical because an
undesirable rise or fall in inflationary expectations can generate a self-fulfilling mechanism.
Should inflation expectations become unhinged, it would be difficult and costly for the
monetary authority to re-establish price stability.
Third, communicating an explicit inflation objective will clarify the Fed's intentions regarding
the level of inflation it considers consistent with its mandate. Some economists have
suggested that raising our inflation goal above 2 percent would be an effective tool for
lowering real interest rates. I am very wary of such a strategy because I don't believe we can
control inflation expectations that precisely. It is at least questionable whether we could
credibly raise inflation expectations. And were we able to do so, how easily would we be able
to bring them back down? Trying to manipulate the public's expectations may risk
undermining the Fed's credibility and the public's confidence in the institution.
Fourth, we eventually will need to normalize our monetary policy and exit this period of
extraordinary accommodation. Having an explicit inflation objective will help us maintain our
commitment to price stability while we do that and increase the credibility of that commitment
in the eyes of the public.
As business leaders, you understand the importance of credibility in your own institutions. An
institution's reputation is built on its credibility for fulfilling its commitments. Once that
foundation is compromised, it is very difficult to rebuild. The Fed must do all it can to
preserve its hard-earned credibility. I believe an explicit inflation goal can help us do that.
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.
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. We remain vigilant on
inflation and committed to clear communication of our monetary policy. 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. 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 the markets. It will also help at a
time when some may view the fiscal situation as threatening the independence of monetary
policy. And it will help in the future, during the eventual exit from these extraordinarily
accommodative measures.