NEW YORK (MNI) – The following is the first part of the text of a
speech by Charles Plosser, president of the Federal Reserve Bank of
Philidelphia to the Shadow Open Market Committee in New York on the
framework for long-run monetary policy, March 25:

It is a pleasure to be here today with my old colleagues and
friends. I spent the better part of 15 years as a member of the Shadow
Open Market Committee and served as its co-chair with Anna Schwartz for
part of that time. It was a valuable experience and I learned a great
deal from our discussions and debates concerning policy.

When I accepted the position with the Federal Reserve Bank of
Philadelphia in 2006, some of my colleagues thought that I had gone over
to the dark side. I preferred to think of it as trying to help put the
lessons of modern macroeconomics and monetary theory to work in the
making of policy. That has turned out to be easier said than done for a
number of reasons, not the least of which is the onset of the greatest
financial crisis since the Great Depression. Some might think, based on
temporal ordering or a test of Granger causality, that it was my arrival
at the Fed that actually caused the crisis. Yet, we should be cautious
in drawing conclusions about causation from such evidence. Personally,
I prefer to think the crisis occurred despite my arrival at the Fed.
But that is a story for another day.

The financial crisis was, indeed, an extraordinary event, and the
Federal Reserve’s decisions to adopt nontraditional policies in an
attempt to stabilize financial markets and the real economy have taken
it far from the traditional and well-understood operating framework for
conducting monetary policy. Our traditional instrument of monetary
policy – the federal funds rate – has been near zero for more than two
years and is controlled within a range but not precisely. The Fed’s
balance sheet is nearly three times as large as it was before the
crisis, and it is heavily weighted toward long-term Treasuries and
mortgage-related assets.

Although recent global events have created some uncertainties, the
apparent strengthening of the U.S. economy suggests it is prudent for
policymakers to develop a strategy for the normalization of monetary
policy. Today I want to suggest such a strategy. As always, and
perhaps particularly so today, the views I express are my own and do not
necessarily represent those of the Federal Reserve System or my
colleagues on the Federal Open Market Committee.

Economic Outlook

Let me begin by noting that the economy has gained significant
strength and momentum since late last summer and seems to be on a much
firmer foundation going forward. Consumer spending continues to expand
at a reasonably robust pace, and business investment, particularly on
equipment and software, continues to support overall growth. 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. Indeed, the
nonresidential real estate sector is likely to improve as the overall
economy gains ground.

The tragic events in Japan and the potential for sharply higher oil
prices given the turmoil in the Middle East and North Africa pose some
risk to our recovery. Yet, I believe this risk is small and short term,
assuming Japan is able to stabilize its nuclear reactors and political
unrest in the Middle East does not dramatically disrupt Saudi Arabia,
the region’s largest oil producer.

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. To avoid this outcome,
the Fed must confront at least two challenges. The first is selecting
the appropriate time to begin unwinding the accommodation. The second
is how to use the available tools to move monetary policy toward a more
neutral stance over time. Policymakers will have to consider other
important and broader issues as well, including the scope of central
bank responsibilities, the appropriate demarcation between monetary and
fiscal policies, and the moral hazard implications of our nontraditional
actions. But these are not my topic for today, as I have spoken on
these issues elsewhere. Nor will I be focusing on the choice of when
to begin reversing course. That, too, is a difficult issue, but not an
unusual one.

My focus today will be on the design of an exit strategy. How do
we execute an exit from extraordinary accommodation and nontraditional
policies and move toward a more traditional operating framework for
monetary policy?

The Monetary Policy Operating Framework After Exit

In designing an effective exit strategy, we must start by deciding
what the operating framework should look like at the end of the process.
We must then articulate a systematic approach that will get us to that
framework in a reasonable time frame. The approach must be easily
communicated and thus transparent to the public and the markets, so that
they understand not just where we are headed but how we plan to get
there.

Of course, monetary policy actions should be dependent on economic
conditions, that is, state contingent, and the exit strategy should be
as well. While there is very little economic theory to guide systematic
policymaking using nontraditional tools, we nonetheless should not act
with complete discretion. I have frequently advocated a systematic
approach to policy and our exit strategy should be no different. Such
a systematic approach reduces uncertainty by offering a degree of
commitment by policymakers to the exit strategy.

So where do we want to go? My preferred operating framework for
conducting monetary policy in the future has four elements.

First, monetary policy should operate using the federal funds rate
as its policy instrument. Because the Fed can now pay interest on
reserves, monetary policy could use the interest rate on reserves (IOR)
as its instrument, establishing a floor for rates and allow reserves to
be supplied in an elastic manner. However, targeting the federal funds
rate is more familiar to both the markets and policymakers than is an
administered rate paid on reserves. To make the funds rate the primary
policy instrument, the target federal funds rate would be set above the
rate paid on reserves and below the discount or primary credit rate that
banks pay when they borrow from the Fed. This operating framework is
sometimes referred to as a corridor or channel system and is used by a
number of other central banks around the world. I have argued
elsewhere that our goal should be to operate with a corridor system
instead of a floor system, in part because it constrains the size of the
balance sheet while the floor system does not.

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