Plosser Speech

I tend to like Charles Plosser's speeches, and this recent one is no exception. Plosser has an excellent understanding of why central bank commitment to a policy rule is a good thing, and communicates the idea well to a lay audience.

Here is one of the interesting parts:

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.

We do indeed face ills. A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions - QE1, QE2, "forward guidance," and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

In commenting on his dissent at the August FOMC meeting, Plosser states:

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 mid-2013. And in my view, given the outlook, economic conditions will likely warrant that the Fed begin to raise rates before that time.

This is essentially identical to Kocherlakota's justification for his dissent at the same meeting, and it makes sense. While the August FOMC decision may look like it implies more commitment, it actually gives less, as Plosser points out. If inflation happens to be much higher than the Fed forecasts (in fact a serious possibility, given the policy) then there are two possibilities. First, the Fed could choose not to tighten, in which case it loses its credibility for controlling inflation. Second, the Fed could choose to tighten, in which case it violates the promise it made in August. Either way credibility is lost and we are actually worse off than if the FOMC had not made the announcement it did in August.

Finally, Plosser discusses inflation targeting:

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.

Some people think that the Humphrey Hawkins Act constrains the Fed in such a way that it must speak directly to the second part of the dual mandate, typically in terms of specific goals for the labor market. However, Plosser gives us a way out. Just as many other central banks in the world do, the Fed could announce specific inflation targets (or a price level target, if you like that better). This need not require any authorization from Congress, as the Fed can argue that this actually speaks to the dual mandate. And that is not a lie, as indeed a wide class of economic models tells us just that. In general, the long-run costs of inflation are reflected in real GDP and employment. Further, there are models of short-run nonneutralities of money in which price stability implies that real GDP and employment are maximized. For example, some New Keynesian models work that way.