Sunday, October 08, 2006

New kid on the block: Charles Plosser as president of the Philly Fed

One of my favorite activities over the past five years has been to attend the semi-annual meetings of a group of economists called the Shadow Open Market Committee (SOMC) as a non-member public observer. As the name suggests, the group meets to discuss monetary policy. The meetings are usually held in April/May and October/November in Washington, D.C. at the Cato Institute, one of the leading Washington "think tanks". I just happened to notice on Friday that the lead co-chair of the committee, Charles Plosser of the University of Rochester, was recently appointed to be the new president of the Federal Reserve Bank of Philadelpha. I'm sure this is a great new opportunity for him and he is certainly qualified for the position, but it does leave the future of "The Shadow" a bit up in the air.

Charles made his first public speech as president of the "Philly Fed" last week, entitled "The Economy, Inflation, and Monetary Policy." Basically, he lays out his model for how the Fed should approach monetary policy. He offers three principles:

  1. "price stability is and should be the primary focus of monetary policy."
  2. "a credible commitment to price stability is an essential part of effective monetary policy."
  3. "monetary policy cannot control output or employment in the short-run, but it should respond to changing economic conditions."

That second principle is excruciatingly vital and has been a frequent topic of discussion at the SOMC meetings. It simply is not enough to do the right thing, but the Fed also has to be believed by the markets, investors, businesses, workers, and consumers to be doing the right thing for the long term. People make decisions about investments, contracts, and purchases based on what they perceive inflation might be years from now.

Based his three principles, Charles assesses "our current circumstance" and has three conclusions:

  1. "there is a significant possibility that inflation rates will remain above those consistent with price stability for some time."
  2. "this prolonged period of relatively high inflation runs the risk of undermining public confidence in our commitment to price stability, thereby raising the cost to the economy of restoring price stability."
  3. "the overall economy is likely to return to its potential growth rate in 2007."

He certainly comes down as a "hawk" on inflation. While quite a number of economists and pundits are calling for Fed rate cuts in 2007, Charles takes the opposing position and states that "the predominant risks ... are on the inflation side" and that "maintaining the current stance of policy, or even firming further, may be in the best interests of the economy¬ís long run performance." That does not mean that he is absolutely firmly committed to raising interest rates, stating his position that "the Fed must keep a careful eye on the pace of economic activity and be prepared to adjust its policy in either direction."

This is all consistent with positions that Charles and the rest of the Shadow Open Market Committee have staked out over the years.

That said, I don't happen to agree with all of the hawkish tone of his outlook in the sense that I believe that there are enough market forces coming down the pike that will likely lead to disinflation. I agree that there is a risk that inflation might pop up, but I happen to worry a little more that business spending might be a little too weak. Besides, one only has to look at the droopy tail of the Treasury yield curve to see that despite what commentators might suggest, true investors are willing to invest as if they do in fact believe that inflation is expected to be reasonably low in the years to come despite being higher than desired in the near term.

I do have to admit that even if my outlook is correct and inflation does moderate over the next two years, the "inflation hawks" do an invaluable service by helping long-term investors believe that they can depend on the hawks to come down very hard on inflation if for whatever reasons it does happen to break out.

In any case, it is good to hear a crisp new voice in the public debate, especially one that I have some background with and some experience interpreting over a number of years.

-- Jack Krupansky


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