Why the Federal Reserve Matters

David Leonhardt of The New York Times has an article today where he explains bias in policy making at the Federal Reserve:

One group of Fed officials and watchers worries constantly about the prospect of rising inflation, no matter what the economy is doing. Some of them are haunted by the inflation of the 1970s and worry it may return at any time. Others spend much of their time with bank executives or big investors, who generally have more to lose from high inflation than from high unemployment. There is no equivalent group — at least not one as influential — that obsesses over unemployment. Instead, the other side of the debate tends to be dominated by moderates, like Ben Bernanke, the Fed chairman, and [former Fed governor Laurence] Meyer, who sometimes worry about inflation and sometimes about unemployment. The result is a bias that can distort the Fed’s decision-making.

You can see this bias in action at the Federal Reserve Bank of Philadelphia. In a speech in July 2008, the President of the Philadelphia Fed Charles Plosser sounded the inflation alarm:

Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned
around.

With food and energy prices rising rapidly in early 2008, Plosser argued in his closing that policymakers must pay attention to headline inflation (estimates of inflation that include volatile food and energy prices):

Since energy price increases have been so persistent in recent years, I do believe more attention should now be paid to measures of headline inflation in setting monetary policy. I don't believe we can be sanguine that the behavior of core inflation will keep the public's inflation expectations well-anchored in the face of persistently high headline inflation. To keep inflation expectations anchored means that monetary policymakers will have to back up their words with action.

Plosser's obsession with inflation caused him to miss even in July 2008 the full consequences of the collapsing housing bubble.  Two months after Plosser's speech, most of the financial system was relying on the Federal Reserve and the U.S. Treasury to avoid bankruptcy, and job losses had mushroomed into the worst the labor market has experienced since the Great Depression.

Flash forward to 2011, and Plosser's obsession with runaway inflation remains as strong as ever.

When Plosser gave his speech, unemployment was 5.8%; today it stands at 8.9%. The Congressional Budget Office is projecting unemployment to remain above 5% through 2015 and annual inflation over the same period to never run higher than 2% a year. 

But with recent spikes in food and energy prices, Plosser is back in the headlines:

Labor market conditions are improving. Firms are adding to their payrolls, which will result in continued modest declines in the unemployment rate. The residential and commercial real estate sectors remain weak but appear to have stabilized. Nevertheless, I do not believe that weakness in these sectors will prevent a broader economic recovery...

If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy. Failure to do so in a timely manner could have serious consequences for inflation and economic stability in the future.

It seems Plosser is in that group of people who mysteriously only talk about runaway inflation and never about runaway deflation, as the consumer price index (CPI) ebbs and flows with volatile food and energy prices (Paul Krugman explains). The following figure plots the CPI (what Plosser refers to as headline inflation) against MIT's Billion Price Index, which predicts pretty well trends in the CPI and seems to suggest some easing of inflation ahead.

So why should the strange and one-sided obsession of one man matter?  The unemployment rate in the City of Philadelphia remains above 10%.  Most of the people living in Philadelphia have probably never heard of Charles Plosser, but in the months ahead, his obsession with inflation will be pivotal in determining whether the Federal Reserve continues its policy aimed at boosting economic growth.  A reversal of policy at the Federal Reserve would slow the pace of this economic recovery and make sure that projections of an unemployment rate of 6% in 2015 prove to be wildly optimistic.

Normally, I would urge you to call your elected representative, but they play no role in electing Charles Plosser to his current position.  The only people with the power to rein in Plosser are the members of the Philadelphia Federal Reserve Board who represent the public.  Listed below are those board members.

Charles P. Pizzi
President & CEO
Tasty Baking Company, Philadelphia, PA

Jeremy Nowak
President & CEO
The Reinvestment Fund, Philadelphia, PA

Michael F. Camardo
Retired Executive Vice President
Lockheed Martin Information & Technology Services,
Cherry Hill, NJ

Keith S. Campbell
Chairman
Mannington Mills, Inc., Salem, NJ

Deborah M. Fretz
President & CEO
Sunoco Logistics, Philadelphia, PA

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