Fed's Plosser on the idiocy of relying on monetary policy to create jobs

He is described as an inflation hawk, but, he still doesn't even have the guts to dissent the way that Hoenig did.  He and Richard Fisher, Dallas Fed Chief, could together send a strong signal that an easy money policy will not and cannot create jobs. 

So if anything, end the employment mandate that allows the Fed to become a poltical tool of Congress.  Via WSJ:

Mr. Plosser's answer is unequivocal: This mess was caused by over-investment in housing, and bringing down unemployment will be a gradual process. "You can't change the carpenter into a nurse easily, and you can't change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they'll find jobs in other industries. But monetary policy can't retrain people. Monetary policy can't fix those problems."

Mr. Plosser reminds me that when QE2 was first proposed last year, he wasn't in favor. "I didn't think it was necessary and I thought that the costs outweighed the benefits." He says he thought that "it carried some very significant risks" that "would not be borne today but would be borne down the road when the time comes to unwind what we've been doing."

But last month, when Mr. Plosser got his first chance to vote on the FOMC, he didn't dissent. When I ask why, he launches into a summary of his four principles of good policy-making: "clear communication of objectives," "credible commitments toward achieving those objectives," "transparency" and "independence."

Credibility demands that the bank not "stomp on the brakes and then floor the accelerator," he says. "Why do you want to signal something and then yank it out from under the market? That's just not a good way to conduct policy."

I'm skeptical that policy makers will know when to change course, so I ask Mr. Plosser what signals he'll be looking for. He begins by cautioning that "with food and commodity prices, as well as oil prices for that matter, the challenge you always face is distinguishing relative price movements from price-level movements." For this reason, he tries "to get a feel for the underlying trends."

And how does he do that? By examining changes in the consumer price index's headline and core inflation, in the growth of the economy, and in employment figures. But he also pays a lot of attention to inflation expectations "because they can be a source of inflationary pressure all on their own."

Mr. Plosser says he likes to look at surveys, one of which, the Philadelphia Fed's "business outlook survey," is particularly "interesting" right now. The survey asks manufacturers about the prices they pay for their inputs and the prices they charge for their products. Businesses often feel, Mr. Plosser points out, that they are getting squeezed on inputs and yet can't raise prices. But over the last three months, the survey indicator has gone from "negative in November, minus-3, to plus-3 in December, [and then] to plus-17." In other words, "manufacturers are beginning to raise their prices."

But might it be too late to stop an inflation spiral if the committee waits too long for confirmation of pricing pressure? "That's why I focus on growth rates," says Mr. Plosser. "Many people like to focus on output gaps"—a measure of slack in the economy—"and stuff like that, which I don't believe in. I'd rather focus on the growth rate of the economy, the growth rate of employment, and the growth rates of prices and expectations of prices. By looking at growth rates, you react earlier."

Speaking of reacting, I'd like to know what is to be done when all this newly created money starts chasing too few goods. One possibility is to stop QE2. Another is to stop reinvesting the cash flow from the Fed's portfolio of mortgage-backed securities, so that the balance sheet shrinks naturally. "Or you can raise the interest rate on [excess] reserves" in the banking system.

Those reserves are another signal that Mr. Plosser is watching closely. "We have all these excess reserves sitting in the banking system, a trillion-plus excess reserves," he says. This is money that banks choose to hold rather than lend out. "As long as [the excess reserves] are just sitting there, they are only the fuel for inflation, they are not actually causing inflation. But they could, because when banks convert those excess reserves into loans . . . we could see a very rapid increase in liquidity," he says. "That would be a very important signal, to me, that we are going to have to start reining in those excess reserves. Otherwise, if they flow out too rapidly, we will potentially face some serious inflationary pressures.

"If banks suddenly decide that there are loan opportunities out there that are attractive and they'd rather make those loans than keep the money [for a .25% annual return] at the Fed, what we don't know is how quickly we'll have to raise those rates in order to prevent all those reserves from flowing out. Maybe it will be just gradual. But the risk is that we'd have to raise rates really quickly."

If that happens, says Mr. Plosser, the Fed would be "faced with a dilemma" because "some people will be worried that we will stifle the recovery."

Are there other ways out? "We could sell assets," he says, and thereby take dollars out of circulation. But that too sounds risky. "It depends on how rapidly rates go up and how rapidly we have to sell [the bonds]." He points out that selling them before rates go up would allow the Fed to avoid capital losses. That's because when interest rates go up, bond prices go down.

Could selling assets also stifle the recovery? Mr. Plosser says it might work out fine, but it might not. Dumping all those securities on the market would push bond prices down and interest rates up. "Suppose then the political hue and cry comes up and says 'Oh, you can't do that, you're disrupting the housing market, you're driving mortgage rates up.'"

In other words, the Fed would feel political heat for not letting the good times roll. "So then the Fed is faced with a situation whether it's either going to fight that political battle and say 'We don't care, we have to do this.' Or it's going to tolerate more inflation" by refusing to act. (I should note that Mr. Plosser says that inflation expectations "are not out of line yet" and that "they have been fairly stable over the course of the crisis.")

The Fed has enormous discretion, and it has not even been clear what its end game is for QE2. And as it turns out, there isn't one end game. There are two.

"When the FOMC came out for QE2, we had two different explanations for what we were doing," Mr. Plosser explains. "One was that we were trying to raise inflation expectations. And the other was that we were trying to lower real interest rates. So, okay, if those were our objectives, how would we determine if we were successful? Were you really worried about deflation or were you really worried about unemployment?"
To stop this kind of thing from recurring, Mr. Plosser would like to see a rules-based Fed. "One of the things we have learned about policy is that rules dominate discretion. Limiting discretion— tying the hands of policy makers to only behave in limited dimensions—is usually a good thing."

He adds that the Dodd-Frank banking-reform bill failed to deal with this problem, especially regarding banks considered too big to fail. "There's still lots of discretion in Dodd-Frank," he says. Then he dreams out loud: "It'd be nice if we could get into a debate about what's the best rule to follow. We may disagree, but just getting to the point where we could discuss the various benefits of different rules" would be progress.

His personal pick would be an inflation target. This gets back to credibility, one of his four principles of policy making. "The central bank in a country with a fiat currency is the only entity capable and responsible for ensuring price stability. Nobody else can do it. That's why the central bank exists. So it's got to be that that's job one."


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