The presidents of three Federal Reserve Banks discussed the Fed’s role in America's recovery from the economic recession at a Dec. 1 panel arranged by and for University of Chicago undergraduates and sponsored by the Becker Friedman Institute.
Charles Evans (Chicago); Narayana Kocherlakota, PhD '87 (Minneapolis); and Charles Plosser, PhD '76 (Philadelphia), shared their views on target rates for inflation, interest rates, unemployment, and other aspects of monetary policy with a student audience of more than 200. Each noted that they were expressing their own views, not official Fed policy.
Welcoming the audience, Institute Research Director Lars Peter Hansen pointed out that this joint appearance was quite rare, and a great example of the Institute’s efforts to offer undergraduates access to leaders in economics, law, business, and policy. Fourth-year student Asher Gabara moderated the conversation with the central bankers.
In January 2012, the Federal Open Market Committee announced that 2 percent inflation is a desirable limit, and with a target of 5.25 to 6 percent unemployment.
Evans said that for more than two years, he has been making the case for greater accommodation from the Fed to improve economic outcomes. He favors keeping interest rates low until unemployment declines to 6.5 percent, as long as inflation stays below 2.5 percent. He shared his reasoning: “I'm led to think this way because I’ve considered economic theory and the best stochastic models, and they all seem to indicate a need to continue” greater accommodation.
His approach builds in a safeguard at 3 percent inflation, in case inflation takes off more than expected.
Kocherlakota was in general agreement with Evans, noting, “Monetary policy is, if anything, too tight, not too easy.” He has proposed that as long as longer-term inflation expectations remain stable, the FOMC will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2.25 percent or the unemployment rate falls below a threshold value of 5.5 percent.
He said careful analysis of structural and demand-based explanations for stubbornly high unemployment has caused him to shift his views. He once blamed the hiring lag on structural factors such as a mismatch between available jobs and worker skills or employer uncertainty.
“What I’ve seen in last two years has caused me to put more emphasis on demand-side issues,” he said. Evidence from current micro- and macroeconomic academic research and the Fed’s own work has lowered his inflation expectations. “I expect it to stay in the low 2 percent,’ he stated.
A More Cautious View
Charles Plosser expressed concerns about using forward guidance—“the idea that if you can commit to keeping rates low, people will feel better about the economy” and they will behave accordingly. He pointed out common defects in the models being used to justify forward guidance.
Forward guidance will only work if it is clear and credible, Plosser added. “Not only must [the Fed] commit, but the public has to understand what our usual response would be and how [our actions] differ from our typical response. That’s a complicated thing to communicate,” Plosser continued.
“I’m worried that these strategies are going to sow more confusion than clarity. I’m terribly worried that we are asking too much of monetary policy and explicitly contradicting the 2012 consensus statement.’’
Plosser said he was convinced of the benefits of current policy, particularly the asset purchase program that is pumping money into the economy, but is much more cautious about the long-term impact of the expansive policy his colleagues favor. The Fed’s massive response is unprecedented, Plosser said, and “we haven’t gotten the outcomes we’re aiming for. We could say either we haven’t done enough, or could say we don’t have the right models. We should be a little more humble about the state of our knowledge.”
Kocherlakota and Evans agreed that humility is key. “I don’t know which answers are the right ones. That’s why I advocate a 3 percent inflation safeguard,” Evans noted.
Plosser addressed the challenges of managing the Fed’s multiple mandates to achieve maximum employment, stable prices, and moderate interest rates. “I’m personally very comfortable with a single mandate or a hierarchical set of mandates. Paul Volker often said price stability is the most important. The Fed is the only institution that can deliver price stability, so in some sense, it should be primary. But we cannot ignore the state of the economy.”
Nominal GDP Targeting
Asked about the prospect of the Fed adopting a target for nominal gross domestic product growth, Evans said he would favor something like that for its signaling value to markets and households, but thinks use of such a tool lies in the future.
Kocherlakota thought it would be challenging to set a correct path for economic output. “I don’t think of nominal GDP targeting as congruent with dual mandate we’ve been set by Congress,” he added. Plosser agreed, noting that setting such a target suggests indifference about how much growth comes from inflation and unemployment. “I don’t think we’re indifferent.”
Kocherlakota, a former student of Hansen, joked that tough questions aimed his way were payback for “being a little bit of a pain” with his own questions in his UChicago days. Nonetheless, the panelists cheerfully took questions from students in the audience. In response to students, they said:
- They expect to continue to keep paying interest on bank’s excess reserves, and that this will be a useful tool when inflation rises and the Fed needs to reverse current policy.
- Securitization has sometimes been blamed too much for the recent financial crisis. Kocherlakota pointed out that financial crises have cropped up since Roman times, and most of them have occurred before securitization had ever been considered. The presidents agreed that securitization is in general a very valuable tool, but that investors underestimated the probability of a market wide collapse in asset prices. Enthusiasm for these financial products led to such complex instruments that even sophisticated investors didn't understand what they were buying.
- The risks to the U.S. from a recession in Europe lie mainly in reduced demand from a key trading partner, uncertainty, and flight to “safe” assets that puts pressure on interest rates the Fed is trying to deliver to the economy. However, Plosser also expressed concern that the European situation puts growing pressure central banks to help solve a fiscal problem, and called that “a dangerous road.”
The institute gratefully acknowledges the CME Group for their generous support of this event. We also thank Asher Gabara, Defne Ozultan, Oeconomica, and other student volunteers for organizing the panel.