Charles Plosser on Monetary Policy and Financial Stability

Sept 8: Philadelphia Fed President Charles Plosser on Monetary Policy and Financial Stability.This is a really interesting speech. But before I dig into it, some background: Since the beginning of the current credit market turmoil, there have been repeated and vocal calls for a significant reduction in the Fed Funds rate. Fedspeak so far has focused on other policy responses to the credit market liquidity crunch, specifically through aggressive discount window lending. The Fed has acknowledged that there are now greater downside risks to the outlook, but maintained that a Fed Funds rate cut would be contingent on incoming macro data (as opposed to credit market data) showing a deterioration in the real economy. So far the employment report has come in weak, but the ISM index and the Beige Book were neutral. Meanwhile, in his concluding remarks at the Jackson Hole symposium, the head of the NBER, Martin Feldstein, suggested that the Fed should cut rates immediately, possibly by as much as 100 bps. Plosser's speech is a repudiation of that view:

Temporary disturbances that don’t affect the forecast for inflation and growth over the time horizon that monetary policy affects the economy do not necessitate a change in the target funds rate. But shocks that have a more lasting impact and cause the forecast for inflation and growth to deviate significantly from the FOMC’s goals do call for a change in monetary policy.

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The U.S. economy has proven to be very resilient to all sorts of shocks over the past several decades. In part this reflects the fact that not all sectors of the economy move together, and a decline in one sector does not always imply major problems in the economy as a whole.

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When information indicates that the outlook for economic growth and inflation has changed, one still has to ask whether it has changed enough to impede the achievement of the Fed’s goals of price stability and maximum sustainable economic growth. As I mentioned, the economy is remarkably resilient. One must also ask how much monetary policy can influence that forecast over the relevant time horizon. Thus the Committee usually does not base its decision to change monetary policy on any one number, but instead assesses the cumulative impact of all incoming data for the outlook in light of its ultimate goals.

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Policymakers must be careful to allow the marketplace to make necessary corrections in asset prices. To do otherwise would risk misallocating resources and risk-bearing, as well as raise moral hazard problems. This could ultimately increase, rather than reduce, risks to the financial system.

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Providing liquidity in the face of a financial shock that threatens the orderly functioning of markets is an important function of the central bank. The Fed has taken extraordinary steps at other times in the past two decades to help keep financial markets functioning. It is important to realize that doing so does not necessarily require a change in the target fed funds rate.

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In those cases when financial shocks lead to substantial and sustained reassessments of the economic outlook in relation to the Fed’s ultimate objectives for price stability and economic growth, the Fed may have to take actions, not only to address the financial shock, but to change monetary policy as well.

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I believe disruptions in financial markets can be addressed using the tools available to the Federal Reserve without necessarily having to make a shift in the overall direction of monetary policy. A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth.

The remainder of the speech focuses on the tools the Fed has available, other than the Fed Funds rate target, to deal with financial stability issues. It should be clear from that focus that the Fed wants to solve this problem without resorting to the very blunt tool of significant Fed Funds rate cuts.

Yves Smith and Calculated Risk have addition commentary on the speech.