Saturday, December 02, 2006

Charles Plosser's outlook for the economy and monetary policy

Charles Plosser, the new president of the Federal Reserve Bank of Philadelphia presented his perspective on the outlook for the economy and monetary policy (PDF) at the Annual Economic Outlook Seminar at the William E. Simon Graduate School of Business Administration at the University of Rochester on Tuesday. It is a very readable and very objective summary of current economic conditions and inflation and monetary policy and the outlook for 2007. He has made presentations on this topic in past years at this same seminar as he was a professor at the school before his appointment to be a Fed president in August.

His overall summary of the economy:

Overall, I think the economy, despite recent slowing, is still in pretty good shape and that the fundamentals are present for a return to growth near trend in 2007.

One catch is that he believe that "trend growth" is no longer a robust 3.5% annual GDP growth, but "closer to 3 percent than 3.5 percent." This is due to a slowdown of productivity growth. So, he says that "when I say that growth should return to trend in 2007, I am expecting that growth will be near 3 percent." He adds that "it should not surprise or concern us to see growth slowing from its pace of the last few years."

He continues to express concern about the risks of inflation, or as he puts it, "I am not as sanguine about the prospects for inflation." His conception for how the Fed should think about inflation is based on the idea that "Ultimately, broad-based inflation on a sustained basis is a monetary phenomenon." His position on inflation is that:

The risk of allowing inflation to remain too high for too long is that it will become embedded in market expectations. Once that occurs, the Fed will lose credibility, and it will be costly to regain it. That was one of the important lessons of the inflation episode of the 1970s. Once the higher rates of inflation were built into nominal interest rates and price setting, the Fed had to reassert its commitment to get and keep inflation low. The price the economy had to pay was high in terms of lost output and high unemployment. We simply do not want to pay that price again. Thus, it is critical that the Fed continue to re-assert its commitment to price stability and to take the actions necessary to back up that commitment.

He notes that inflation over the past several years has not simply been an oil prices story, but also medical care, personal care products and services, and education.

I would note that he refrains from offering a numerical forecast for inflation in 2007, probably reflecting the ongoing discussions at the Fed about numerical inflation targeting. His outlook for inflation (and hence monetary policy) is stated as:

Now, over the past two years, the FOMC has moved the federal funds rate up considerably from its historically low levels, so it is possible that inflation could return to acceptable levels without further policy actions. On the other hand, the fed funds rate adjusted for inflation remains relatively low. Thus, to my mind, there remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon.

He concludes:

All of this suggests to me that while the Fed must keep a careful eye on the pace of economic activity and be prepared to adjust its policy in either direction, at present, the predominant risks – and the attendant economic costs – are on the inflation side. So we need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy’s long-run performance.

In short, he is certainly not suggesting that the next Fed move is likely to be a cut, but more likely would be a hike. No hike would be necessary if inflation continues to back down, but there simply isn't enough evidence to assert that this is certain. My own, tenuous, belief is that inflation will tick down enough to keep the Fed on hold, albeit with a continued level of discomfort, and that it may take another year or even two before inflation retreats back into the comfortable 1% to 2% range. I think the Fed will be semi-happy if they get inflation in the 2% to 2.5% range in 2007.

-- Jack Krupansky

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