Can a Rule-Based Approach to Monetary Policy Enhance Economic Growth and Stability?

Thursday, May 8, 2014
Charles I. Plosser

President and Chief Executive Officer, Federal Reserve Bank of Philadelphia

Joyce Chang

Managing Director and Global Head of Research, J.P. Morgan

Philadelphia Fed President Charles I. Plosser joins Joyce Chang of J.P. Morgan to discuss his views on monetary policymaking. Plosser advocates for a systematic monetary policy in which discretion and judgment are replaced by a more rule-based approach of reacting in predictable ways to particular economic conditions. He also shares his thoughts on the state of the economic recovery and says that the U.S. economy appears poised to return to stronger growth rates following a weak first quarter.

This meeting is part of the C. Peter McColough Series on International Economics, presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

CHANG: Well, this month marks the one-year anniversary since the start of Fed taper talk, and I can think of no topic more timely than today's discussion which will focus on communication and transparency in the conduct of systematic monetary policy.

I'm honored to have the privilege to introduce today's speaker. Charles Plosser in his current role as president and chief executive officer of the Federal Reserve Bank of Philadelphia participates on the Federal Reserve System's Federal Open Market Committee, which is responsible for conducting the nation's monetary policy. He also served on the subcommittee led by current Fed Chair Janet Yellen, which specifically focused on improving communications, a topic that has taken on heightened importance as the Fed reduces its asset purchase program.

Dr. Plosser joined the Philadelphia Fed in 2006. During his term, he and his colleagues have faced the challenges of a global financial crisis followed by a severe recession. The Fed took unprecedented actions in both monetary policy and in its lending operations that helped mitigate the effects of the crisis and address deteriorating economic growth.

After the crisis, as the financial regulatory reform was being debated, Dr. Plosser stressed the need to preserve the Fed's independence and structure by drawing a distinct line between fiscal and monetary policy. He also argued that reform must end the notion that any firm is considered too big to fail or risk sowing the seeds of the next financial crisis.

Dr. Plosser, as we will hear today, believes in a systematic approach to monetary policy, to promote better economic outcomes and financial stability. He's also been a long-time advocate of the Federal Reserve adopting an explicit inflation target, which the FOMC adopted in January 2012.

Before joining the Fed, Dr. Plosser was an economics professor and served as the dean of the University of Rochester's Business School for 20 years. He was also the coeditor of the Journal of Monetary Economics for 20 years. Please join me in welcoming Dr. Plosser to the podium.


PLOSSER: Thank you, Joyce, very much for that kind introduction. It's really a pleasure to be back here at the Council on Foreign Relations. It's been a few years since I was last here, and it's a very enjoyable event, and it leads to sort of really insightful and useful conversations.

And I do know that in these sessions the fun oftentimes and the value oftentimes arises during the discussion, so I'm going to try to keep my opening remarks a bit brief. But as they say, sometimes you can take the professor out of the classroom, but you can't take the classroom out of the professor, so sometimes I tend to ramble, but I'm going to try to keep it brief.

But before I go any further, I do like to apply the usual disclaimer that these views are my own and not necessarily those of my colleagues on the FOMC at this point. And they are always deeply appreciative of that caveat that I always try to put out.


So the topic I want to address today is communication and transparency in the conduct of monetary policy. Many of you in this room, I suspect, can recall when it was taken for granted that central banks—a central bank was supposed to be secretive and mysterious. The guiding principle was simple: The less said about monetary policy, the better. Indeed, it wasn't until 1994 that the Federal Open Market Committee began to announce its policy changes at the end of its meetings.

But times have changed. Transparency has replaced secrecy, and open communications has replaced mystery. The extent of this transformation is, in many ways, quite remarkable. Today, the issues of communication and transparency are front-and-center on the agenda of meetings and conferences on central bankings around the world.

Now, a major reason for this focus on these issues is the recognition that the stance of monetary policy encompasses not just the current level of the short-term policy rate, but its expected future path, as well. More broadly, economists have come to understand that expectations, including expectations about monetary policy, play an important role in determining economic outcomes, such as real economic growth and inflation.

Of course, one element of communication that's received a great deal of attention of late is forward guidance. Forward guidance, of course, is central bankers' speak for communication about the future course of monetary policy, and particularly about the course of the short-term policy rate. One reason for this increased attention on the future path of policy is that short-term rates have been constrained by the zero lower bound. So then, under what conditions, people ask, will the nominal rate eventually rise, once—once the nominal rate begins to rise takes on greater significance, that is, the future path becomes more important.

However, forward guidance is not a separate or independent tool of policy. Its effectiveness is intimately interrelated to other features of monetary policy. In particular, a credible, systematic approach to policy and the general openness and transparency of the policy process are essential elements in shaping expectations. Even with this recognition, there are various views about how best to communicate information about the intended path of policy and how to ensure that such information is credible. Indeed, if it is not credible, it will not shape expectations in the beneficial way some people would like.

More generally, a central bank can and often does communicate on a host of important issues, including its view on the current state of the economy, its assessment of risks, and its outlook for key economic variables. Perhaps most important, from my perspective, is communication about how the evolution of key economic variables will systematically shape current and future policy decisions.

So in my remarks this morning, I wanted to stress the importance of the FOMC's efforts to articulate such a systematic approach to policy. Doing so is likely to make forward guidance more effective by helping the public better understand and interpret what that guidance actually means.

So what do I really mean by systematic approach to policy? Well, quite simply, I mean conducting policy more in a rule-like manner. The antithesis of such rule-like behavior, of course, is discretion, that is, policymaking conducted period by period with great latitude to take on whatever actions seem best at the time.

Now, this rules-versus-discretion debate in is an old one in economics. It dates back to Henry Simons back in 1936 at least. Yet following the Nobel Prize-winning work of Finn Kydland and Ed Prescott in 1977, most academic economists—but, unfortunately, far fewer policymakers—have come to accept the benefits of adhering to rule-like behavior in monetary policy.

These benefits arise in part because consumers and businesses are forward-looking, and credible commitments concerning the determination of the future path of policy can alter expectations in ways that can make current policy more effective and less uncertain. The ability to behave systematically and to align the public's expectations with the—with this systematic behavior allows the central bank to do things it otherwise couldn't do, particularly at the zero lower bound. It could increase output while simultaneously lowering inflation, for example. But a credible commitment to honor past promises is an essential element of rule-like policymaking. Discretionary policymaking, discretionary decision-making more general undermines those commitments.

Now, the appropriate way to make policy more systematic, or rule-like, is to base policy decisions on the state of the economy. That is, policymakers should describe the reaction function that determines how current and future policy rates will be set depending on the state of the economy.

Now, of course, policymakers are no more certain about the future economic conditions than anyone else is, and therefore, it cannot realistically commit to particular future values of the policy rate. Nonetheless, by describing a reaction function of some kind or rule that explains how the policy rate will be determined in the future as a function of economic conditions can be highly informative and beneficial.

Of course, unfortunately, the science of monetary policy has not reached the point where we can specify a rule for setting policy and turn decision-making over a computer—over to a computer. Judgment is clearly still required. Nevertheless, I place a great deal of importance on systematic behavior, both as a prescription for good policy and in terms of my own policy deliberations.

Now, of course, there's been a great deal of policy done—a great deal of research done on various types of rules. The most well-known, of course, is that done by John Taylor. John Taylor—the Taylor rule is a reaction function that describes how to set the policy rates as a function of deviations of inflation from a target and some measure of economic underutilization or slack.

Now, the attractiveness of Taylor-like rules for monetary policy goes beyond their intuitive appeal or the fact that they seem to describe the actual behavior of monetary policy reasonably well. The reality is, is that Taylor-like rules yield very good results in a variety of theoretical settings.

While this result is surprising to some, it's of enormous practical importance. Given our uncertainty about the true model of the economy, knowing that systematic policy in the form of a Taylor-like rule delivers good outcomes in a variety of models means that these simple, robust rules can provide useful guides for policy.

Systematic policies that provide important information about the policymakers' reaction function combined with other information, such as the policymakers' economic forecasts of the economy and the variables that go into that reaction function, can sharpen forward guidance in a way that reduces policy uncertainty and enhances economic performance. Thus, well-designed communications are valuable, and behaving systematically has the added advantage of making those communications easier to the public—easier to explain to the public and easier for the public to understand.

Well, what else should the central bank convey? For example, should it publish forecasts of variables in its policy reaction function, and should these forecasts be based on the likely path that the policy rate will follow, what some people call the conditional forecast, or on some other set of assumptions?

Now, many central banks publish forecasts in what they often call detailed inflation or monetary policy reports. But there is still debate about the nature of the forecasts and the assumptions that underlie them. For example, who owns the forecast? At some central banks, the forecast is that of the policy committee itself and thus represents a type of consensus forecast, if you will. In other cases, the forecast is that of the central bank staff. Individual policymakers who may or may not fully buy into the staff forecast are then free to express their own independent views about the outlook. That's also fairly common.

A critical piece of any forecast emanating from the central bank is the nature of the future path of policy rate. So should a central bank's published forecast be based on its own assessment of what the policy rate path is likely to be, perhaps based on its reaction function, if it has one, what we call an unconditional forecast? Or should the forecast be based on an interest rate path that is more arbitrary, such as a constant interest rate path or perhaps an interest rate's path as determined based on market expectations inferred from some set of forward rates? Others question whether a central bank should reveal the forecast's interest rate path at all.

Perhaps the greatest fear from policymakers in preventing—that prevents most central banks from publishing their best guess of the path of rates is that the public will assume these projections will be taken as a commitment to that path rather than a projection.

In my view, such fears could be mitigated if the policymakers would articulate the way they plan to systematically or way they expect to systematically adjust policy in response to economic conditions.

Now, while I've suggested potential problems that central banks—for central banks as they publication an assessment of the likely near-term path of policy, in conjunction with a forecast, there's also a major benefit, namely the added discipline that it places on the policy process itself.

As I alluded to in my opening introduction, monetary policy does not just affect the economy through its setting of the current interest rate, but also through the expected path of the policy rate. Providing information about how that path is likely to evolve forces policymakers to think more deeply and systematically about how they are conducting policy. Communication about that path, in turn, gives the public a much deeper understanding of the analytical approach that guides monetary policy. Again, my view is that policy transparency and forward guidance could be enhanced if the central bank was more explicit in articulating its approach to policymaking.

So I'm fully aware that great care needs to be taken in providing more specific forms of forward guidance so that we avoid the false sense of certainty that it may convey and a mistaken sense of commitment. Yet I believe that systematic policymaking can enhance economic performance, and therefore, I favor clearer communications concerning it and the—and the articulation of policy.

In a stylized world, if there's a single policymaker, monetary policymaker who has considerable confidence in the model of the economy, effective communication would include a forecast derived from this model. This forecast would incorporate a policy path that yields the best outcomes based on what—based on that single policymaker's views.

However, we don't live in such a simple world. Monetary policymaking is often conducted by committee, and divergent views can and often do exist. While this can be clumsy at times, such governance mechanisms have great strength in preventing institutions from lapsing into groupthink and by ensuring that various views are heard in an environment that promotes better decisions and outcomes and helps preserve the central bank's independence and its accountability.

Thus, it may be difficult for the FOMC to achieve a consensus forecast or agreed-upon policy path. But there are other things we can do. One way is to enhance the communication would be to indicate the likely behavior of interest rates based on some different Taylor-like rules that have been consistent with monetary policy in the past. Doing so would require an agreement on a particular model to use for that exercise to make valuable comparisons.

For the board—I mean, for the Fed, the board staff's economic model that we often call FRB/US seems like a reasonable place to start. The FOMC could then articulate whether and why it anticipates policy to be somewhat more restrained or more accommodative relative to the projections in that model or the paths of policy that are explored. A more comprehensive monetary policy report—in some countries, it's called an inflation report—might accompany such a forecast and include various views about the baselines and about how different policymakers may have different perspectives.

And I actually think that performing this exercise would indicate the inherent uncertainty that policymakers face—because we do, we face lots of uncertainty—yet it would also give a better sense of the likely direction of policy and the variables most related to systematic policy. Further, this type of communication would push the FOMC, I think, to conduct policy in a more analytical, more systematic manner, and I think that would lead to better economic outcomes over the longer term.

So I'll stop there. Thank you.


CHANG: Thank you so much, Dr. Plosser. You know, I'd like to go to yesterday's testimony by Janet Yellen, her first testimony before the Congress, and she very successfully dodged any attempt to attach more specific guidance on the timing of the first Fed hike, even when goaded by the committee chair, who seemed to repeatedly go after her with a range of dates as to when to expect the first hike. In clear contrast to her six months comments at the March press conference, she spoke very much in broad generalities. So to look back at the key lessons learned that were drawn from the experiences surrounding last May to August's tapering discussions, what would you articulate as the key lessons learned on the subsequent policy announcements, as well as the actual start of the Fed tapering process?

PLOSSER: Well, I think—the way I describe our communications—I think the fair way—I've talked about this in other venues at times—is this notion of transparency and communications is a bit of a journey. It's not an end result at the end of the day. And central banks all around the world are struggling with figuring out how to communicate what's most effective, what to communicate in some cases.

And I think that—so we're never going to get it exactly right. So I think that's one lesson to be learned. I also think the lesson is, the more specificity we try to offer about specific outcomes, particularly outcomes about policy, the more specificity we try to couch our forward guidance in terms of those outcomes makes it more difficult, because at the end of the day—and the chair—Janet made this very clear in the press conference at the last—after the March meeting—she made it very clear that she did mention six months, but in that same sentence was a phrase that said, but of course it depends on the evolution of the data, how the economy evolves. People seem to have forgot that part of the sentence.

And at the end of the day, it does depend on how the economy evolves. And so my view about systematic policy or reaction functions, if you will, is the more we can make it clear about how those decisions relate to the economy, not to the calendar, the better off we'll be. That doesn't mean there won't be uncertainty about the future path of policy, because we don't know what the future path of the economy is going to be very precisely, either. That means policy rates in the future will be uncertain, but they'll be uncertain mostly about uncertainty about the economy, not uncertainty about how the policy decision would be made.

And so that's one of the reasons I'd like to see us move to being a bit more explicit and willing to say how we are going to react to the economy in what ways, and we can do that in a fairly qualitative manner. I don't think we have to make it mechanistic at this point. But the more we can convey that sense, I think the better off both monetary policy will be and the better off the economy would be.

CHANG: Well, let's go to the economy now. So the 6.5 percent unemployment threshold looks increasingly irrelevant, but we've really had a mix of data, a difficult first quarter, and in practically every part of the world, inflation that's well below target in most of the world. So how are you looking at where we are in the recovery, the potential growth rate for the U.S. economy, post-financial crisis? You know, what explains the inflation trends that we've been seeing? You know, that's been the dog that hasn't barked so far.

PLOSSER: So as far as the economy is concerned, I actually am reasonably optimistic about the economy. I've said since the beginning of this crisis, I have never been one of those that forecasted the kind of V-shaped recovery where you get 4.5 percent or 5 percent growth coming out. I've always believed that this was going to be a difficult recovery, for a variety of reasons.

And so—but, having said that, I think if I look at the economy during the first quarter, I am—as the data—recent data have come in, I'm more and more convinced that a lot of the weakness that we saw in the first quarter was, in fact, weather-related. The numbers that have come in over the last few weeks and few—and month seem to be indicating a pretty good bounce-back in both manufacturing outcomes. Consumer has done pretty well. And so I think that—so I'm actually encouraged by the recent data, and that the first quarter, while it was not very pretty—it was maybe white and cold, but it was not very pretty from an economic standpoint—I'm encouraged that things are actually looking a lot better.

And so I still believe that, for the rest of this year, we're going to see something like a 3 percent growth for the rest of the year. Now, the overall year will be lower because of the first quarter, but I still think we're on track for about a 3 percent growth.

"My view about systematic policy or reaction functions, if you will, is the more we can make it clear about how those decisions relate to the economy, not to the calendar, the better off we'll be."

In terms of inflation, inflation has been a bit of a puzzle for many people. I think that there are things we don't fully understand about the dynamics of inflation, particularly in the short run. So I think there's a lot of evidence that some of the inflationary weakness, if you will, or below target outcomes in the United States have been the contribution of some temporary factors and one-time events have contributed to that.

I think we'll begin to see how much they contributed to that over the next quarter or so, as some of those one-time events fade away from the year-over-year year averages. So I'm still expecting inflation to drift back up towards target, but perhaps slowly.

Why inflation is lower in other countries is—you know, may be unique to those countries, as well. So I don't want to really get into that, but your observation is correct. Certainly the most obvious one is Europe, and, of course, Japan's a different story altogether.

But—so I'm still reasonably confident that inflation is going to drift up back up towards our target. I think a tougher question for the FOMC will be if it doesn't. Then we're going to have to ask the question, well, what can we do about that? What should we do about it? What can we do about it in the short run?

My own view is that monetary policy for the last five years, we've generated in excess of $2.5 trillion of excess reserves sitting in the banking system. A lot of that's just sitting there, and it's not inflationary as long as it's sitting in the banking system. But at some point, as the economy begins to grow and evolve, the incentives for those banks to move those excess reserves out of the Fed and into loans and other lending, that's going to grow. And as that grows, those reserves are going to flow out of the economy. That's going to create potentially lots of money.

"If I look at the economy during the first quarter, I am—as the recent data have come in, I'm more and more convinced that a lot of the weakness that we saw in the first quarter was, in fact, weather-related."

So I don't think we have a problem in the longer term of allowing inflation to rise back towards our target, because the economy improves and those reserves flow out, the Fed in principle can control that flow in a way that gets us back to our target, by letting more money flow out to the economy.

Now, that's in principle. I don't think that adding more excess reserve to the banking system will do anything for inflation in the short term. So I don't see any point in adding more. We've got plenty there once they start moving out.

So I'm not sure that we have many tools in the short run to raise inflation. So I think our strategy for me—my strategy is to think about—talking about inflation in two ways. One is reassert our commitment that we have a target of 2 percent and our intention is, over the longer run, to meet that target. The worst thing we could have is inflation expectations beginning to fall. That would be more problematic. They haven't yet, but to fall.

So I think we need to reassert our commitment to our target and communicate that we will conduct policy in the future, as we exit from this extraordinary period, in a way that gets us back to that target. That is our intention, and that's what we should do, and so that's the way—at least in the near term—I think we ought to think about talking about inflation, but then again, that's just the way I think about it.

CHANG: So maybe a final question before I open it up to the members here. You mentioned false sense of security, too much groupthink, and that's what I worry about looking at financial markets. We have equity markets that are back to new highs, debt issuance at a record level, record low volatility. Are you worried about an asset bubble, that asset inflation is running way ahead of where it should be? Are we sowing the seeds of another financial crisis at this stage?

PLOSSER: So financial bubbles and financial crises are very hard to predict; I think we have a lot of case studies that tell us that that's hard to predict. So I don't know the answer to that.

In the past, I have expressed concern that central banks around the world, not just in the United States, but around the world have taken some extraordinary actions that put us in places where we've never been before. Those efforts were courageous efforts in many cases to counteract a financial crisis in one case and in—and in the latter cases to sort of stimulate the economy by driving rates down and then long-term rates down and so forth.

I do think we need to be careful in thinking about monetary policy as the solution to so many of our ills and that we need to be aware that these extraordinary actions may have unintended consequences that we have yet to be able to understand. And we don't really know how this will manifest itself. Maybe everything will go smoothly. I'm hopeful that it will. But I would also suggest that financial markets are not always patient. Policymakers—no matter where they are—like to think everything can be—all adjustments can be smooth and gradual and everybody, you know, can adjust to them. It's not often the case.

So I am concerned that there are some unintended consequences. If you believe that monetary policymakers have suppressed risk premium or term premium of various kinds, and we've driven rates well below where markets would like them to be, then at some point when we remove that accommodation and move that distortion, if you will, and those rates have to adjust back to more normal or market-based fundamentals, how will that happen? Will it happen quickly? Will it happen abruptly? Will it be painful? Or will it be gradual and smooth?

And there are a lot of questions like that we don't know the answer to. And I think that—I think that interpretation for me is that that behooves us to be not worried just about risk to the economy of the external forces, whether that be Congress or whether that be Japan or geopolitical forces or China, that we need to be worried about risks that actually we place into the economy through our extreme policies, and that should be part of our risk assessment of the economy, as well.

CHANG: And so very—very good discussion here. So let me now open and invite members to join our conversation with their questions. A few ground rules. Please wait for the microphone, speak directly into the microphone, and then please stand and then state your name and affiliation. And do remember that all questions are on-the-record today.

So I'd like to invite members—any members who have questions. Yes, Amitabh?

QUESTION: Amitabh Arora, Citigroup. I'm just curious. The virtue of the Taylor rule is there's two variables and you can have a linear relationship. With a broader set of variables, for example, there's a big debate about what the true output gap is. How might you want to operationalize this more rule-based—what you're suggesting? In some sense, the FOMC is trying to do that. How—how might you want to go a step further?

"I do think we need to be careful in thinking about monetary policy as the solution to so many of our ills and that we need to be aware that these extraordinary actions may have unintended consequences that we have yet to be able to understand."

PLOSSER: So let me take a step back to our statement in March, because for the last year, we've had these thresholds we've called them, the 6.5 percent and the 2.5 percent inflation forecast threshold. Those were useful guideposts, but they're not a reaction function. They're just described points. So it doesn't really tell you much about how we'll react at different places between those numbers, for example.

So I don't think that was as helpful as it might have been. So notice I said Taylor-like rules. There are lots of rules out there. And there's been lots of work that have explored what I call and others have called robust rules, rules that work well in a variety of models. And they're not exactly the same. The coefficients can be different, and the variables can be somewhat different, but there's a lot we have begun to understand about what makes those robust rules.

I am not naive enough to believe that we can sit down at an FOMC meeting and 19 people around the table are going to agree on a particular rule, mechanical rule. I think that would be a very ambitious and not likely very successful task.

But the Fed already looks at rules. We looked at a variety of rules that we talk about, that we explore, we kind of monitor on the side, and so it seems to me that the first step we could take is do two things. One, do what we did in the statement in March when we—or when—was it January? I forget. They all run together after a while. When we remove the 6.5 percent and gave a more qualitative description of the reaction function. And I thought that was actually a very good step forward. It got us away from focusing on some points and talked about how we would adjust policy depending on how the progress that we make towards our objectives.

Well, that's kind of like a gap, right? It's how far are you away from your—if it's an inflation target and you're below that, as you get closer to that, you would adjust policy according to that. And so we talked about that in words in that statement, and I thought that was actually a good step forward. I would have liked us to have been a little more explicit about that, but it was a movement towards talking about talking about a, what are we going to be reacting to?

So I think that was a good step forward. The next step would, it seems to me, would be—I'd like us to see—see us have an inflation report. I'd like to see a forecast in there, even if it's not a consensus forecast, and I'd like us to be able to talk about what different rule specifications imply for the path of interest rates, not that we will follow those precisely, but you are giving guidelines or ranges, if you will, or guidance about the kind of things the committee is looking at.

I think we could do that without committing to anything. And that would convey a couple of things to me. It would convey information about how we think about the future path of policy. Perhaps most importantly, it would begin to communicate about the uncertainty that really exists out there in the world and what different rules would imply for different forecasts or different outcomes.

So I think there are things we can do to be more open about this and more transparent without necessarily reaching a point where we sit down and write down a linear formula that we all, you know, sign up on. So I think this is—that's why I say communication and transparency is a bit of a journey. You know, you start small. You increment. You add stuff. You become more—you understand how to communicate things, and you're going to make some mistakes along the way, but you're not going to get very far unless you begin to try and do some things differently.

And I would like us to try to experiment a little more, be a little more open, and be a little more explicit. And, again, back to this—try to convey something about the true uncertainty that we really face, because it is large. And I think markets and even the Fed at times gets too fixated on point forecast. You know, we put on the SEP, the Summary of Economic Projections, and it moves two-tenths of a basis point, and all of a sudden people get worried that we've marked down our forecast. You know, it's hard to get excited about two-tenths of a basis point on anything—or two-tenths of a percent on growth.

So I think we need to sort of step back and sort of become a little more—have a little more humility and a little more clarity about uncertainty, and I think actually that would help—help the markets understand that things can't be as predictable and as guaranteed as you might like it.

CHANG: Thank you very much. Next question, please?

QUESTION: Allison Schrager. I might not be understanding forward guidance totally, but the way I understand it...

PLOSSER: You're probably not alone.


QUESTION: Because it feels to me a lot like discretion now, rules later, or discretion on what rules we follow later. And how does that get around dynamic inconsistency?

PLOSSER: Well, discretion doesn't get around dynamic inconsistency. That's part of the problem. So, you know, I've said in other speeches, I think my problem with the forward guidance as we've tried to implement it—I understand what we're trying to do, but you can't simultaneously be discretionary and make commitments to forward guidance. They're just—they're anathema to each other.

So if you want forward guidance to work, as I said in my remarks, you've got to commit to following through on the promise that you made, right? And if you constantly say, well, it depends or I could change my mind or it's really not cast in stone, then forward guidance of that form will not be very effective, because for it to work, it's essential the people believe that you're going to do what you say you're going to do and you're committed to it and nothing will change that.

And to the extent that you equivocate on that, then the effectiveness of giving that type of forward guidance—the beneficial effects of that now are weakened. So that's the reason why I kind of come—rather than offering forward guidance as if it was some independent tool that you can manipulate people's expectations and do that sort of when you want to and not do it when you don't want to, I think that's a fool's errand, so to speak.

And that's kind of why I believe—I like to think about forward guidance more as sort of, what is our reaction function? How do we anticipate setting policy if the economy does X, for example? That's a form of forward guidance that doesn't commit you to a particular policy path, but it does explain something about how you're going to react as the economy evolves.

I think that may be the best we can do, in terms of forward guidance, and that ties in to a broader way of conducting policy, where you're more transparent about that reaction function. You talk about it. You explain it. You describe your policy decision in terms of what happened to these key economic variables and why you made a policy decision or why you think the future path of policy may have changed, because your forecast of those variables is changing.

And I think that is likely to be a better way to talk about policymaking and perhaps be more successful in conveying something useful to the public than the sort of one-off promises that we don't really—that we may or may not be able to keep anyway, but it is a debate—I guess another way to describe it, this is still a debate about rules versus discretion. A lot of people like to call it hawks and doves, but in part, it's really about rules versus discretion.

And I think that's a very important debate, and how you think about that—how you think about that governs how you think about your communications, it seems to me.

CHANG: Yes, Allen?

QUESTION: Thank you. Allen Hyman, Columbia Presbyterian. You spoke about the weather. And yesterday, Janet Yellen invoked an unanticipated, unusually severe winter as one reason for the first quarter output below her expectations. An act of God, if you will. Global warming is inevitable. It's certain, but it's variable in intensity and in location. So I'm asking you, how should climate change influence the Fed's forecasts or the parameters of the Fed's forecasts? And are there climatologists on the board's staff?

PLOSSER: I don't know of any climatologists on the board's staff, unless there are some with a hobby of climatology, so I don't know about that. Well, I think—the way I think about it is, is you talk about uncertainty and long-run effects. There are lots of things in the very long run that, A, we can't control—maybe we can in this case, doing certain things—but they're going to be—it's hard to predict. And as you mentioned, they're going to show up in different ways and different things, if it is important.

I think the only way our economic models in general—at least our forecasting models, where we're forecasting a year or two years out, the only way in which those will be impacted by this is that if the broader economic data evolve in ways that force those—the parameters of those models to change in some way. And since these models are always re-estimated using more data, it's going to take—it's going to be kind of a Bayesian or a database activity that will lead to changes in the model, if that's required, because the data will tell us it's required.

QUESTION: It's hard.

PLOSSER: It's hard, yes.


CHANG: Professor Feldstein?

QUESTION: Marty Feldstein, Harvard University. On the reaction function question, it's clear that the—that Janet Yellen is focused very much on the issue of slack in the labor market, but if we can look ahead to a time when the inflation rate is above 2 percent, do you think that the Fed's reaction function even in a qualitative sense has been made clear about how the FOMC would respond if inflation was above 2 percent and rising, but there was still significant slack in labor markets, particularly long-term unemployment?

PLOSSER: So, no, I don't think we've been clear about that at all, which is why I think we need to add some more clarity about that. You know, for—and I don't want to get too focused on the Taylor rule, because actually the rules I tend to sort of think about are ones that are a little more robust than that, what—rules that look at growth rates or differences, that sort of try to get away from the level effects of estimating the level of potential GDP or the natural rate, or what have you.

But my point is, is that something like a Taylor rule helps you set the level of the funds rate, given however you choose to measure slack and your departures from inflation. And so it takes both pieces of the mandate, if you will, into account.

And so people look at a range of rules now, for example, of these robust rules, and the simple Taylor rule, the simple Taylor rule says that even though inflation's only at 1 percent, that given the current estimate of the output gap, rates ought to be higher than zero. Already tells you that. So it takes into account the fact that inflation's too low. Likewise, if the output gap didn't close and inflation went above, it would tell you to still set rates higher in that sense, so it gives you a guide—it gives you the guides that you—the guidelines that you want.

And so I think it's important that we—to me, a reaction function is not one that I'm free to change the parameters, the coefficients, if you will, or the intercept willy-nilly as a discretionary policymaker. I don't think that's the way you do it, because then it just becomes discretion again.

So I think we need to specify both elements of that. Now, I personally have my own preferences on some of this stuff, in terms of how I think about the difficulty of measuring real gaps in the first place, but we need to spell that out more, and we really haven't—we haven't done that.

The Fed over its history—and, Marty, you know this as well as I do—tends to bounce from one objective to the other. You know, inflation's too low, so we focus on that, or employment's too high, so we focus on that, without ever really talking about how you—how they fit together to getting to one policy decision. And if you keep allowing your objective—the parameters on your rule to go from zero to one as you see fit, you're defeating the purpose of having the rule in the first place. And I don't think we've been as explicit about that as we should.

I mean, even if the Fed were today raise—I'm not suggesting they are—but were to raise interest rates by 50 basis points, monetary policy by most of these rules would still be incredibly accommodative, all right? Just being accommodative doesn't mean you have to stay at zero. You can still be accommodative relative to some of these rules.

So I think those are some of the challenges that we have in communication. What do we mean by more accommodative than normal? Well, we haven't defined what normal would have been. So I think this is the challenge we face of how to communicate those things. Does that sort of answer your...

CHANG: Two questions over here. I'm going to go first to you.

QUESTION: Mickey Levy, Blenheim Capital Management. OK, so Congress provides—gives a mandate to the Fed, and the Fed is independent in executing that mandate. I want to ask the question about your communications and transparency with the Congress, that is supposed to be supervising you. OK, so are—in your subcommittee on communications, have you ever discussed whether you're satisfied with how you are communicating and how transparent you are with Congress, kind of moving them up the learning curve? Because it's—I find it quite striking that everybody seems generally satisfied that the Fed chair twice a year provides a report and—have you ever discussed ways that you might improve on those kind of communications, on a Congress that should know more about what the Fed does and what it's capable and incapable of doing?

PLOSSER: So I'm going to—I have—I'm very strongly in favor of transparency and communicating as clearly as we possibly can. I mentioned the options for something that—in some countries, you know, the Bank of England has an inflation report. Other banks have things that kind of look like that. We have a monetary policy report that's—it used to be called the Humphrey-Hawkins testimony report.

Yes, I would think about my own view—why don't we think about what we can do with that report to make it more like the kind of communication that I was trying to talk about, more talking about—talk more about our forecasts, talk more about our policy perspectives, and describing the sort of ways and analytics that we want to go about and we think about? How can we transform and make that something that brings the Fed's communication strategies kind of up to where some other central banks have achieved those kind of reports?

So I think we can transform that, and that would benefit not just our communication with Congress, but with the public more broadly. So I don't really see communicating with Congress necessarily something distinct from being open and transparent to the public more broadly. So I think if we do—if we pursue this, then we're going to help accomplish that goal, as well, I think. That would be my hope.

CHANG: Yes, a question here, and then we'll go to the...

QUESTION: Good morning, Dr. Plosser. My name is Joe Naggar with GoldenTree. My question is—I have two questions for you. The first one is, is how should we think about the labor participation rate? And sort of how do you think about it? And, you know, just to put it in perspective, someone had made a comment—well, you know, the unemployment rate's 6.3 percent, but if you actually had the labor participation rate where it was, you know, five years ago, it would be 12 percent. You know, and that's—obviously, a very heavy-handed comment, but I just want to see how you think about that.


QUESTION: And the second—second question—sorry—is just very simply, what are the top two or three things that concern you most about the economy right now?

PLOSSER: So let me talk a little bit about the participation rate. I think there are a lot of things that are going on in the labor market that we as economists and labor economists, we don't fully understand what's going on. There's been a lot of shocks and a lot of things have changed. Participation rate in general, there are sort of two features to that that I think are—that we need to keep in mind.

The first is, is that labor force participation rates have been declining since about 2000. They've been on a fairly steady decline. And the reason for that is something we know something about, is just demographics. Our population is getting older. The baby boomers are retiring. And so the mix of people—elderly is growing as a proportion of the whole economy, and as a consequence, labor force participation rates are falling.

That part's kind of baked in the cake. So I think it's a mistake, to take your question at face value, to believe that somehow we're going to get labor force participation rates back to where they were five or six years ago. I think that's—that would be, to me, not a very fruitful way to say what our objective ought to be. Forget the Fed, just as a policy matter, I think that would be a tough task, any more than I think that we ought to, you know, create—return the housing market to what it looked like in 2006. I'm not sure that's where we want to be either. That didn't turn out so well, so maybe you don't want to be there, either.

But so—there is a trend decline in labor force participation rate. The debate we have is sort of, how much of that's due to this—how much of the decline is actually due to this purely demographic issue? How much of it has been due to traditional cyclical factors? And therefore, where do we think it's going to end up?

A lot of the dropping out of the labor force, as I said, is purely age-related. But there are other things that are going on in the labor force, as well. The number of—that are fairly—well, one is disability. In the 1990s, the Congress changed the rules for disability insurance. The growth in individuals who are on disability now has been a trending—been trending up and accounts for about a third of the fall in labor force participation rate since the beginning of the recession, OK, or since the last peak. So that's contributing to a decline in labor force participation rate.

The other thing is retirements more generally. There are probably people who, for example, were near retirement when the recession hit, maybe they lost their job, maybe they were 60 years old or 59 or 62 or somewhere in that—maybe in that margin, who concluded that—maybe as the stock market went back up—concluded that, OK, I was going to retire in three years anyway, and I don't have a job, so I might as well just go ahead and retire and move on.

And so the recession did cause perhaps some of them to retire perhaps earlier than they were planning on. But the evidence is, is that once you retire—at least in the surveys and data that we have—once you retire, you don't come back. And once you go on disability, you don't come back.

So those two—those two groups, disability and retirements, account for about 75 percent or 70 percent—the people have different estimates, but somewhere in that order of magnitude—of the decline in labor force participation. They're not coming back.

So that remains—that leaves the—whatever the other 25 percent of the decline is to be assigned to maybe cyclical or what they call discouraged workers or other things. That may, in fact, come back. We don't know for sure.

But it interacts with a whole bunch of other things that are going on in the labor market. It goes back to what's happening in skills and the types of jobs that are being created. It goes back to—many people are going back to school. People worry about the long-term unemployed, and we should. Many of them are back in school, presumably repairing their skills or updating their skills for hopefully employment later on.

And there's this trend that Janet Yellen has talked about that we worry about, is sort of the high level of part-time employment. Part-time employment went up a lot like it did—like it often does in recessions, but it hasn't declined very much, which is unusual.

I don't think as economists we understand that very—we don't understand exactly what's going on there. We don't know whether that's a permanent shift in the way—the structure of our labor markets. I spend a lot of time talking with businesspeople around the district and around the country and world, and, you know, many of them will tell you, they're just—they're hiring people differently than they ever have before.

And they are hiring them on shorter term. They're hiring them on contracts. They want a more flexible workforce. You know, many of them will cite issues about health care costs of employing people full-time. There's a wide range of factors that are playing into that that I don't think we fully understand.

So I think we have to be cautious about believing that particularly monetary policy tools are the right tools to sort of address some of these issues, because I don't think we understand them quite as well as we need to. So the labor market is a very—it's a bit of a puzzle at this point. And my own assessment is, I still believe the unemployment rate is a pretty good summary statistic of where the labor market is. But there are obviously all these nuances one can draw on, and some of them we just don't have very good answers for.

So what do I worry about? Well, we've talked about some of those things. I worry about the unintended consequences in financial markets. That's certainly something that we need to keep an eye on. There are things—there are geopolitical risks, as we all know. The Fed can't do anything about those. All we can do is sort of watch and keep our fingers crossed like everybody else, but be aware that those are out there.

And so I think that we have to be vigilant and we have to be cautious and we have to understand there are risks. But I do think that both the public and the central bank need to keep in mind that, you know, central banks are not the panaceas for all our economic problems. We have limited tools to use. And, you know—and if we try to use—I also draw the analogy to a doctor. You know, if you go in and if you believe monetary policy is something like a medicine that helps you restore life and health to your patient, you know, if you don't diagnose the disease right and you give the patient the wrong medicine, you can actually do harm.

And so I have to think—we have to think—we have to be careful about the limits of what we can and can't do. And I draw the same analogy with fiscal policy. Some people make the argument, well, fiscal policy is not doing what it should, so the Fed has to offset that somehow. Fiscal policy and monetary policy are not the same thing. They don't work the same way necessarily. And how you use those tools are important. So I think a little more realism and a little more—a little less hubris on the part of both central banks around the world and what the public expects of them is actually called for.

I'm very—I'm very fond of—I was a student of Milton Friedman's, of course, in Chicago, and I'm very fond of his—I won't get the quote quite right, but it's from his 1969 presidential address to the American Economic Association. And it goes something like this. We are in danger of asking monetary policy to play a role larger than it can play to achieve tasks it cannot achieve and in so doing put at risk the contributions it can make.

I think that's a very wise lesson for policymakers and the public to have. And I wish we could get to that point, is my personal opinion.

CHANG: Well, I think that there's time for just one final question over here in the back. You've had your hand up for a while, and we're at time, but a lot of food for thought in this discussion today.

QUESTION: Thank you. Nili Gilbert from Matarin Capital Management. Thank you for your comments this morning, Dr. Plosser. In financial modeling, we find that many of the traditional rules and models that we use for decision-making are limited in the context of years of zero interest rate policy, accompanied by quantitative easing. When you think about rules-based policymaking, are you concerned about similar limitations? And if so, what traditional relationships and models do you view as being particularly at risk?



Where do I start? Let me try to just focus on the zero bound for a moment, when interest rates are zero. The zero lower bound in nominal interest rates does make for particular problems for monetary policy and for our models of monetary policy. It creates some awkward non-linearities and things that don't work like they normally would, like we would think they would work in normal times, and so it's prompted central banks to try lots of new things.

But the way I think about it is, the things that matter at the zero lower bound are things you need to talk about—to operate policy at the zero bound are things you need to talk about before you get there. That is, you need to have a plan or, if you will, a systematic way of thinking about how you're going to conduct policy at the zero bound before you get there, because if you then do it on a sort of reaction—on a sort of ad hoc way or a discretionary way once you get there, the things that the models tell us to do are going to have a harder time being effective.

So I think it's just really—it is—things are complicated at the zero bound. There's no question about that. And we don't really have all the right answers. I mean, there are some models, for example, that tell us at the zero lower bound to use forward guidance, and some of those same models say, don't bother with quantitative easing, because it won't work. Right?

And so we have different ways of thinking about how to operate the zero bound, so it is a problem. So it's probably best to think about—going forward about, how would you—if this ever happened to us again, how would you conduct policy? And there have been some suggestions for that. And I don't want to go into all the details, but there are ways to address that. But it's a hard problem, and it's not easily fixed. It's not easily fixed.

CHANG: Well, thank you so much to all of the members here, to Dr. Plosser for his comments.

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