Fed’s Plosser: Base monetary policy on simple rules

NAPLES, Florida (BestGrowthStock) – Central bankers should base policy on simple rules related to inflation and economic growth and not rely on hazy measures of economic slack in order to stay ahead of the curve, a senior U.S. Federal Reserve official said on Tuesday.

Philadelphia Federal Reserve Bank President Charles Plosser warned that formulating policy based on the difficult-to-measure gap between potential and actual economic output or the gap between the jobless rate and full employment could lead to policy errors.

Relying on output or unemployment gaps to formulate policy, “forces the central bank to operate under a high degree of uncertainty”, he told a forum at the Czech National Bank in Prague, according to prepared remarks.

Policy makers should instead respond “aggressively” to moves in inflation from a target, he said, as well as to measures of economic growth.

“A commitment to systematic behavior has been shown to result in more economic stability and lower inflation,” said Plosser, who is not a voter on the Fed’s policy-setting panel this year.

Fed policy makers are divided on the usefulness of output and unemployment gaps in formulating monetary policy. The more dovish members of the U.S. central bank, such as San Francisco Fed President Janet Yellen, often cite economic slack as a reason that the central bank should keep interest rates low for a long time.

Plosser reiterated his discomfort with such measures, saying they are based on data that are subject to “significant revisions” over time.

“Basing policy on such an ill-measured variable has led to policy errors in the past and could do so in the future as well,” he said.

“My preferred approach also is consistent with the idea that, as economic growth accelerates, the economy’s underlying real rate of interest also rises, signaling the need for tighter monetary policy,” Plosser said.

“This is likely to keep policy ahead of the curve rather than behind it — lowering rates sooner in a cyclical downturn and raising them earlier in a recovery.”

A rule-based approach can also lend more transparency to policy making, Plosser said, as the public can more easily see when policy is deviating from the norm, and policy makers will be forced to explain their actions.

“Because such a rule is transparent and easy to monitor, it helps the public form expectations of future policy,” he said.

Such an approach has “important implications in the current environment as various economies around the world begin to recover from the global financial crisis and the Great Recession,” Plosser said.

“Although there is a good deal of uncertainty about the pace of those recoveries, as the expansions continue, central banks will eventually need to tighten monetary conditions.”

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Fed’s Plosser: Base monetary policy on simple rules