Smith Faculty Opinion Article
The 30 Seconds Outlook
March 1, 2011
“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.”
- Charles Plosser,
President of the Federal Reserve Bank of Philadelphia and
member of the FOMC
Plosser’s interview concerning Fed “rules not discretion” in Mary O’Grady’s
February 21st Wall Street Journal article offers a time tested alternative to
Bernanke’s Fed policy. Some of his other comments are relevant, as well.
With current moderate economic growth and low inflation, the fear of
deflation is losing support. Therefore, the only excuse for QE2 is to reduce
unemployment. However, “this [economic] mess” was caused by over-investment in
housing, and bringing down unemployment will be a gradual process.” . . .
“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 these problems.”
The Fed’s dilemma whether to pursue lower unemployment or reduce the chance
of deflation could be solved if a “rules based policy” were adopted. “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.”. . . “It’d be nice if we could get into a
debate about what’s the best rule to follow.”
The best rule would be to set an inflation target.“ 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 banks
exists. So it’s got to be that that’s job one.”
When banks do begin to lend their huge excess reserves held at the Fed, there
will be a rapid build up of liquidity that will increase inflationary pressures.
Once this happens, the Fed will find it necessary to “reign in” excess reserves
promptly to avoid too much liquidity.
When inflationary pressures do increase, the Fed could (1) stop QE2, (2)
reinvest cash flows from holdings of mortgage-backed securities to shrink the
its balance sheet gradually, or (3) raise the interest rate on (excess) bank
reserves.
To avoid dampening economic growth at the same time, the Fed could sell
assets and take dollars out of circulation, but it would be better to sell them
before inflation sets in and higher interest rates reduce bond prices.
Plosser follows several signals to determine when inflationary pressures
become the problem. At what point do “relative price movements” become “general
price-level movements?” To that end Plosser follows:
- Consumer price index and core inflation.
- Inflation expectations—very important.
- Costs of manufacturing inputs and output prices—output prices are
increasing.
- Economic growth rates.
- Employment growth rates.
- Price growth rates.
- Excess bank reserves--do not yet suggest inflationary pressure.
For persons seeking an end to the loose monetary policy that brought us to
where we are today, Plosser’s comments provide a beacon of hope.
John A. Haslem
