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Overview: Plosser explains that upside risk is more worrying

Phalguni Soni

Overview: Will the Fed's doves and hawks find common ground? (Part 4 of 11)

(Continued from Part 3)

Dr. Charles Plosser

Dr. Charles Plosser has been the head of the Federal Reserve Bank of Philadelphia since August, 2006. As a noted hawk, he’s been a vocal critic of the Fed’s monetary stimulus program. Dr. Plosser is part of the Federal Open Market Committee (or FOMC). He will vote on policy this year.

Dr. Plosser’s views on the economy and inflation

In a recent speech to the Women in Housing and Finance in Washington DC, Dr. Plosser remarked that the “U.S. economy is on a firmer footing today than it has been in several years.” He cited improvements in the housing and labor markets as well as expansion in the manufacturing sector. He believes that “given the recent trends, an unemployment rate below 6% is certainly plausible” by the end of 2014.

Despite inflation (defined by the change in personal consumption expenditures (or PCE)) falling short of its 2% target, Dr. Plosser was confident that it would move towards the Fed’s long-term goal over time. “Given the large amount of monetary accommodation that we’ve added and continue to add to the economy, I think there’s some upside risk to inflation in the longer term.”

On the tapering of asset purchases and the Fed funds rate

Dr. Plosser believes that tapering monthly bond purchases at the current rate, when the economy is showing signs of improving, would have the Fed increasing monetary accommodation when in fact a tighter monetary policy may be in order.

“My own view is that, as we continue to move closer to our 2% inflation goal and the labor market improves, we must be prepared to adjust policy appropriately. That may well require us to begin raising interest rates sooner rather than later.”

Systematic forward guidance for the Fed funds rate

Recently, Dr. Plosser advocated the use of rule-based policy making for the Fed’s monetary policy. Speaking at the Council on Foreign Relations in New York on May 8, Dr. Plosser explained why a systematic approach to determining the Fed’s monetary policy, and communicating the same to financial markets, would lead to better economic outcomes.

The use of Taylor-like rules for determining the path and the level of the Fed funds rate wouldn’t only objectify the Fed’s monetary policy, but also provide better clarity to financial markets while reducing uncertainty. According to Dr. Plosser, “The ability to behave systematically and to align the public’s expectations with that systematic behavior can allow the central bank to increase current economic activity, while simultaneously lowering inflation. But a credible commitment to honor past promises is an essential element of rule-like policy. Discretionary decision-making undermines such commitments.”

What is the Taylor rule?

The Taylor rule was developed by Stanford University economist, John Taylor in 1992. The rule is used to forecast the level of the nominal Fed funds rate due to changes in key macroeconomic variables like inflation and output. The output from the Taylor rule formula gives the nominal base rate. In summary, when the inflation rate in the economy is higher than the central bank’s target rate, the resulting base rate would also be higher. This would suggest that monetary tightening in the economy, through higher base rates, was required. In terms of other macroeconomic variables, if the gross domestic product (or GDP), for example, was lower than the full employment level supported by the economy, the Taylor rule formula would give a lower base rate. This would indicate that an accommodative monetary policy for the economy was in order.

Many central bankers including the dovish Chicago Fed Chief Charles Evans and the centrist James Bullard, head of the St. Louis Fed, have advocated using versions of Taylor-rules in order to clarify the path of future monetary policy. Taylor-like rules would ensure that the Fed’s policy is in line with its twin mandate of full employment and 2% inflation.

“I place a great deal of importance on systematic behavior both as prescription for good policy and in terms of my own policy deliberations,” said Dr. Plosser. “Taylor-like rules do a good job of approximating monetary policy in various theoretical settings and can provide useful guidance in the face of economic uncertainty.”

Investor impact

The S&P 500 Index (VOO) has already touched numerous record highs this year due to the recovering labor market. An increase in the Fed funds rate would likely affect yields in the overall bond market (AGG) including both Treasuries (IEF) and investment-grade corporate bonds (LQD). They would also likely increase the yields and spreads on high-yield debt (HYG).

To read more about Dr. Plosser’s views on financial sector reform, please read the Market Realist series, Why Charles Plosser calls for simplicity in financial regulation.

In the next section in this series, we’ll discuss the views of Richard Fisher, head of the Dallas Fed.

Continue to Part 5

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