Charles Plosser and the Monetary Hawks

Charles Plosser, President of the Philadelphia Fed, is routinely described as a monetary policy "hawk."  I guess that I don't understand what this means.  I do know where he stands by his writing and speeches.

A very clear and readable expression of Dr. Plosser's approach to monetary policy can be found in a paper given to the Inaugural Meeting of the Global Society of Fellows of the Global Interdependence Center, hosted in Paris by the Banque de France, in March 2012. 

He points out the inherent tension between an independent central bank and fiscal authorities.  He notes, "History teaches us that...they (governments) often resort to the printing press to try to escape what appear to be intractable budget problems."  Independence is especially tricky given that monetary policy and fiscal policy are "intertwined through the government budget constraint." 

Everyone agrees that our politicians on both sides of the aisle have been kicking the deficit can down the road for decades.  The severity of the last financial crisis, and cries about "saving the system," led the current Federal Reserve Chairman to cross the boundary into what Professor Jonathan Wright of Johns Hopkins University describes as "unorthodox monetary policies." 

Plosser's paper talks about pressures for the central bank to be "lender of last resort," something which is a hot topic in Europe.  He also cites Federal Reserve establishment of credit facilities to support specific markets for private instruments like commercial paper and mortgage-backed securities.  Support for the latter has turned into massive purchases of MBS, which he says have blurred "the traditional boundaries between fiscal and monetary policy."

Like an overweaning parent kowtowing to a spoiled child, both parties are negatively impacted by the recurring pattern of manipulation by the child and indulgence by the parent.  The current monetary policy environment at the zero bound has, in my opinion, taken a lot of the information content out of market interest rates.  Markets are now driven almost solely by what participants believe the Fed will do in response to perceived macroeconomic risks.  Thus, global markets switch "risk on/risk off" based on the statement of the ECB President.  When the market cries, the Fed comes with some candy and the child feels better.  This is not a good environment in which to allocate capital for long-term projects, which should be the real forte of the financial markets.

Plosser's fundamental objections to the Fed enabling irresponsible behavior by the government fiscal authorities are supported by some innovative econometric work by Professor Wright.  Wright comes to the conclusion that since November 2008, QE1, QE2 and QE3 (maturity extension program) have had "a significant effect on ten-year yields and long-maturity corporate bond yields that wear off over the next few months."

The quantitative easing programs, Professor Wright concludes, "were all characterized by declines in interest rates that were reversed over the subsequent months."  The market behavior seems to have been to move on the announcement effect, overreact on the upside in anticipation of future announcements, and then to correct the overshoot.  

This Federal Reserve, having gone down a political road to underwrite unprecedented fiscal profligacy and excessive financial market risk-taking, may not be able to show the courage to reclaim its independence.  Let's hope that it finds a way to go back to just being the guardian of our currency's value and long-term price stability.    That's a plenty big enough charter.