BFI NewsNov 04, 2015

On Hubris and Humility

Former Fed President Argues for a Narrower Role for Central Banks

Cocktails & Conversations with Charles Plosser and Lars Peter Hansen

Cocktails & Conversations with Charles Plosser and Lars Peter Hansen

Central banks can’t solve all our economic problems and should maintain a narrow scope, focusing on what the tools of monetary policy can do well, according to Charles Plosser, former president of the Federal Reserve Bank of Philadelphia.

Plosser offered this frank assessment in a conversation with Lars Peter Hansen that centered on the Fed’s role and recent challenges:  financial stability and oversight, managing bubbles, influencing labor markets, addressing uncertainty, and setting expectations with forward guidance.

“My personal opinion is that more and more is being asked of central banks that they are not well equipped to do,” Plosser said, noting that since the financial crisis, this has been true around the globe.

He cited Milton Friedman from his 1967 presidential address to the American Economic Association: “‘We are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution it is capable of making.’”

“If ever a quote was apt, that one is today. Monetary policy and central banks can’t solve all the problems we face; it’s dangerous for public and for the banks to think that we can,” Plosser said, calling for central banks to “move more systematically, and be more circumspect in the expectations they set.”

Plosser noted that especially since the 2008–09 financial crisis, circumstances pushed the Fed beyond its traditional, Congressionally sanctioned dual mandate of seeking price stability and maximum employment.

“The big debate has shifted to financial stability, whatever that is,” Plosser said. The relationship between financial stability or financial oversight and monetary policy and how they interact remains “a good question,” he said. “Those things might be in conflict with one another.” For instance, in recent years keeping interest rates low to achieve an employment objective may contribute to financial instability.

“There is a great deal of debate about whether you want to add another mandate to the monetary policy’s list of objectives. My own view is that we have to be very careful asking central banks to do more and more. If you want your institutions to be successful, to be credible, and to achieve objectives, then narrow or more limited goals have an advantage.”

Plosser was skeptical of the Fed’s ability to spot and manage asset price bubbles.

“I don’t know what a bubble is. The track record of policy makers and economists more generally to know whether some price increase constitutes a bubble or not is pretty poor, so the idea that you can have policies to address them is a pretty dubious proposition from the get-go,” he said.

Asked about how much the Fed uses financial market data in its models and policymaking, Plosser said that market prices are helpful because they are forward-looking, but it’s also important to remember that they are also just forecasts, aggregated with other information and subject to uncertainty.

For example, with treasury inflation-protected securities (TIPS), many people interpret the spread or break-even point as a forecast of inflation. “But what we’ve come to realize that there are many pieces of information inside that price. At the height of the crisis, TIPS break-evens were doing very strange things. A lot of it was driven by flight to safety” as the debt crisis in Europe worsened and investors sought safe havens.

The challenge is detangling the embedded information to understand what the price is really signaling.

Plosser agreed with Hansen that the Fed should better acknowledge this kind of uncertainty in the policy process. “This is fundamental. People have to understand there is still a lot we don’t know. Models are enormously helpful, but they don’t always give you the answer. We need to have a little less hubris and a little more humility about what we can do and the precision with which we can act.”

He noted the frustration policymakers faced when Fed forecasts of GDP are revised down from, say, 2.7 percent to 2.5 percent.  Headlines would read, “Fed slashes forecasts.”

“The focus on point forecasts I find objectionable because it sends the wrong message. The Fed needs to talk more about uncertainty and lack of precision.

That means you have to think hard about uncertainty and its implications for policy.”

He noted that one tool for addressing uncertainty is Hansen’s work with Sargent on robustness, which helps assess whether policy decisions work well across range of situations and models.

Hansen asked about the Fed’s attempts at forward guidance, which in his view lacked clarity. Plosser agreed, saying that investors took the wrong signal. “In that sense forward guidance was added confusion and provided little of the advertised benefits,” he said.

The aim of forward guidance was to shape the public’s expectations—in a way that resulted in additional stimulus. To do so required that the public believe that the Fed would act differently than it otherwise would have done. In other words, it would deviate from its normal reaction function.

This approach was why the Fed said it would keep rates lower for longer.  It said in August 2011 that it wouldn’t raise rates before summer 2013. The idea was that by signaling that rates would remain low, investors and consumers would feel confident about the future and invest and spend immediately.

Instead, the perception created was that rates would remain low because the economy was a wreck, and thus saving rates remained high and spending was restrained. “It was not the signal you wanted to send. In fact, was exactly the wrong signal,” he concluded. “Managing, or you might say trying to manipulate, the expectations of the public is fraught with difficulty and can backfire.”

“To be effective, the public must believe that the Fed was making a credible commitment to behave in an unusual way and that it would follow through.  Unfortunately, the Fed always added the caveat that they would be flexible and adapt if the circumstances changed.”

Plosser argued that this illustrated the tension between rules and discretion.  “Acknowledging that you are retaining flexibility is the antithesis of a credible commitment to stick to your promise.” And in fact, Fed did not stick to it, but kept moving the goalposts. “Following through on promises in the form of forward guidance is simply incompatible with discretionary policy making.”

—Toni Shears