Plosser on Productivity and Rate Cuts (9/25/07)

Charles Plosser, President of the Philadelphia Fed, gave a speech today on Invention, Productivity, and the Economy. Plosser has been on the job for about a year now; in terms of FedSpeak, he's been one of the most hawkish members of the FOMC. He doesn't currently have a vote, but he will in 2008, so his views about the how the Fed should respond to recent economic events are of increasing importance.

Productivity is important for two related reasons. First it tells you where the economy's natural speed limit is: potential growth = labor force growth + productivity growth. Second, as a rule-of-thumb, a good estimate of the neutral fed funds rate is potential growth + inflation.

The issue is especially important now, because estimates of recent year-over-year productivity growth by the BLS have been declining:

The question of whether this recent decline is real (the estimates could get revised up), and if so whether it's temporary or permanent is of central importance to the stance of monetary policy.

In Plosser's own words:

In the long run, the economy’s growth rate largely reflects two factors. The first is the growth rate of the labor force, which is determined by demographic factors like the birth rate, age distribution, and immigration. The second is the growth in the productivity of the labor force, which depends on both physical and human capital and incentives for research and innovation. Monetary policy cannot be used to achieve a long-run growth rate that is inconsistent with these economic fundamentals.

[...]

As you know, in recent years, productivity growth has slowed from its very rapid pace in the last half of the 1990s. Although there continues to be much uncertainty about how much of the recent slowdown in productivity growth will prove to be transitory and how much will prove to be persistent, my own view is that trend productivity growth will turn out to be only slightly below 2 percent. And that will mean trend economic growth over the next few years is likely to be close to 2-3/4 percent, slower than the more than 3 percent growth we saw in the late 1990s but not as slow as some economists are forecasting.

So using Plosser's 2.75% trend growth and current core PCE inflation of 1.9% (from table 11 of the BEA's Personal Income and Outlays report), we conclude that Plosser's estimate of a neutral fed funds rate is currently about 4.65%, slightly below the current target of 4.75%.

Now that we have an idea of where neutral is, we can move on to Plosser's take on the economic outlook, which will give us an idea of how much above or below neutral he thinks the funds rate should be.

In early September, the August employment report contained some surprises. It reported an employment decline of 4,000 jobs. My own reaction was to take that number with a grain of salt because August is a tough month to estimate because of back-to-school effects. ... More troubling for the outlook, in my mind, was the downward revision to both June and July employment gains.

While the unemployment rate remains low, the softening of employment gains in the early summer suggests that the labor market may not be quite as tight or as robust as we previously thought. If so, then it may have a dampening effect on income and consumption growth in the months to come. Having said that, I would not be entirely surprised if employment growth rebounded. Nevertheless, a softening labor market is a factor in the revision to my outlook.

Incoming information showing a continuing sharp decline in house prices and weak home sales also contributed to the downward revision to my outlook. The cumulative information on the housing market over the last few months has suggested that the recovery in residential construction is likely to be delayed until later in 2008 than many forecasters originally thought.

Finally, the turbulence in the financial markets has created additional uncertainty. While there is little direct evidence that the financial disruptions have significantly affected the broader economy, that certainly is still a real possibility. One source of that risk is that consumers and businesses may choose to delay or defer spending plans until the future becomes a little clearer. In addition, the general tightening of credit conditions, if persistent, can aggravate and possibly further delay the recovery in housing and further dampen both consumer and business spending.

Well, that's pretty clear. I think it's safe to assume he thinks that monetary policy should be on the stimulative side of neutral.

Now on to the part that's meant for people who weren't paying close enough attention:

Thus the pace of economic activity is likely to be somewhat slower in the next few quarters than I expected earlier. A slower economy means that real interest rates must decline to bring about the appropriate adjustments to restore growth. In recognition of this, I believe last week’s action to lower the fed funds rate target was appropriate.

[...]

It is important to understand that the economy is expected to grow more slowly in the coming months, despite last week’s decision to reduce rates. Therefore, I will not be surprised to see weaker statistics making headlines. But weaker numbers will not lead me to revise my outlook or my view of the appropriate funds rate target, unless they are much weaker than already anticipated and accumulate sufficiently to generate another downward revision in my outlook.

One could quite easily conclude from those two paragraphs that Plosser is in the "one and done" camp. I.e. that the recent 50bp cut is quite sufficient, so don't expect any more cuts.

There are two reason I don't think that's the case. First, we just did the math: Plosser thinks we're at neutral now, and just said the economy is slowing, which requires stimulus. Second, and this is key, when policymakers talk about the "appropriate funds rate target," they are referring both the current rate target, and to an expected path of future rates (which they all have in the back of their minds). It is entirely consistent for a policymaker to say the current rate is appropriate, and to expect to cut rates at the next meeting.

So, if I'm reading this correctly (a big "if"), Plosser has managed to pull off a neat trick. First, he sounds very hawkish to a broad audience, which should help to bring inflation expectations back down a bit. At the same time, he's signaling to the narrow financial market audience, the ones who allocate capital, that it's ok to go ahead and take a bit more risk (which stimulates growth), because the Fed will cut rates again to assure the economy keeps growing near potential.

Very clever.

As alway, views welcome...

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.

...

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.

...

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.