Tuesday, July 22, 2008

Plosser speech on the outlook for the U.S. economy and inflation

Charles Plosser, President of the Philly Fed, delivers a speech about his outlook for the economy and inflation. It is interesting to see that not everyone at the Board of Fed Governors is compromised by unflinching support for ailing Wall Street.

on inflation:
The consequence of our easing of monetary policy is that the inflation-adjusted — or real — interest rate on federal funds is now negative — between minus 1 percent and minus 2 percent. The last time we saw such a negative real fed funds rate was in 2003-2004. But the environment then was much different than it is now. Back then, the Fed was concerned about the threat of deflation. Today, as we all know, this is not the case. Many of us are concerned about rising inflation rates.

Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around.

I want to make clear that the rise in inflation expectations in the 1970s was not caused by a wage-price spiral. That story has things backwards. The wage-price spiral was a consequence of the inflation and the unanchoring of expectations of inflation, not the other way around. And the unanchoring of inflation expectations was caused by the public’s loss of confidence in the Federal Reserve’s resolve to bring inflation back down. The credibility of the Fed’s promise to deliver price stability was lost.

In recent months I have heard some analysts suggest that the current economic situation is not like the 1970s because unions are less prevalent and there is no evidence as yet of a wage-price spiral. Thus, a weak economy, with rising unemployment and declining payroll employment, will presumably prevent workers from demanding higher wages. But, again, that story has things backwards. It is not demands for higher wages that kick off the spiral, but the loss of confidence that the central bank will keep inflation controlled, which, in turn, leads to a rise in inflation expectations. The wage-price spiral is not the cause of the inflation, but the result.

I want to emphasize that what we have been seeing in the economy this past year, and in my own outlook going forward, is very different from the 1970s, because I see the Fed as committed to keeping inflation expectations well-anchored. I agree with a statement Fed Chairman Bernanke made in June that the Fed will strongly resist an erosion of longer-term inflation expectations, because an “unanchoring” of those expectations would be destabilizing for economic growth as well as inflation.

Since energy price increases have been so persistent in recent years, I do believe more attention should now be paid to measures of headline inflation in setting monetary policy. I don’t believe we can be sanguine that the behavior of core inflation will keep the public’s inflation expectations well-anchored in the face of persistently high headline inflation. To keep inflation expectations anchored means that monetary policymakers will have to back up their words with action.

source: Perspectives on the Economy, Inflation, and Monetary Policy
Presented by Charles I. Plosser,
President and Chief Executive Officer, Federal Reserve Bank of Philadelphia

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