–Monetary Policy Focus Should Be On Inflation, Output Growth
–Should Vary Target Int Rate In Line With Est. Real Int Rate Movements

By Brai Odion-Esene

WASHINGTON (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser Thursday voiced his opposition to the use of monetary
policy to combat large upswings in asset prices, arguing that getting
the Fed involved “will more likely be a source of discretionary mischief
and mayhem than stability.”

Rather than “chasing incipient bubbles,” he said monetary policy
should retain its focus on providing price stability as a means to
support sustainable growth in employment and output over the long run.

However, to guard against bubbles, the Fed should raise its target
interest rates in line with increases in underlying real interest rates,
Plosser said in remarks prepared for the Cato Institute’s Annual
Monetary Conference. There was no mention of the Fed’s latest
quantitative easing program.

In the speech, entitled “Bubble, Bubble, Toil and Trouble: A
Dangerous Brew for Monetary Policy,” Plosser said he would not advocate
raising interest rates “simply to lower asset prices when they appear to
deviate from fundamentals.”

Starting off by giving his outlook for the U.S. economy, Plosser
said he is not one of those worried the economy might fall into a
deflationary trap. “Indeed, I am more optimistic than many about the
future path of the economy,” he said.

Yet there are concerns that the Fed’s extremely accommodative
stance is fueling a rapid rise in asset prices similar to that seen in
the housing market prior to the financial meltdown. Plosser warned,
however, that targeting asset bubbles “is a policy that is easy to get
wrong and fraught with risks.”

So, even in the wake of the financial crisis, “I continue to
advocate that the Fed follow a systematic approach that keeps monetary
policy focused squarely on inflation and output growth, but especially
on inflation.”

The Fed official said policy aimed at influencing asset prices
could encourage discretionary actions by the Fed that would draw it ever
deeper into credit allocations and the determination of relative prices.
“That should not be the role of monetary policy,” he said.

Plosser believes that requiring the Fed to tackle asset-price gaps
would push the central bank “well beyond” its capabilities. “It is
challenging enough to calibrate and communicate our policy stance when
we try to balance the perceived tradeoffs between output gaps and
inflation,” he said.

Also, it may be difficult to determine — when asset values rise
sharply in a bubble-like fashion — whether the rise is based on market
fundamentals.

He cautioned that due to the difficulty in discerning a genuine
misalignment of asset prices from a change in asset prices driven by
fundamentals, “monetary policy actions that respond to such price
changes could generate even bigger inefficiencies than those it was
designed to correct.”

Additionally, asset prices are often volatile, Plosser noted, and
creating expectations that the Fed will intervene directly to influence
the price-setting mechanism “seems more dangerous” for the orderly
functioning of markets than helpful even in the rare occasions when a
true and significant distortion may actually exist.

So while using monetary policy to address the misalignment of asset
prices would not necessarily ensure price stability or sustained output
growth, Plosser does have a suggestion.

“In my view of monetary policy, the central bank should
systematically vary its target interest rate in line with movements in
an estimate of the real interest rate,” he said.

So in the face of economic shocks that push up the real interest
rate, Plosser suggested the central bank should respond by raising its
target rate commensurately, as long as inflation is at or near its
target. And if the shocks cause a decrease in the equilibrium real
interest rate, then the central bank should lower its target interest
rate to avoid disinflation.

“The policy approach that I have advocated would increase the
interest rate target in line with the increases in underlying real
interest rates as a systematic form of inflation targeting. That would
most likely lead to raising rates as return on assets also rise,” he
said.

By following a more systematic approach to monetary policy, Plosser
argued, policy actions provide “a natural response” to broad-based
increases in real rates of interest that often accompany asset-price
inflation. This systematic policy, he added, also provides a natural and
predictable response as those rates decline, and does so in the context
of maintaining a low and stable inflation rate.

** Market News International Washington Bureau: 202-371-2121 **

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