WASHINGTON (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser Tuesday said the tightening central banks will be
executing someday soon should be guided by more precise measures than
output gaps.

Speaking to a Czech Republic audience, Plosser said a realization
of the imprecision of concepts commonly used to formulate modern
monetary policy could have “important implications” in a period of
worldwide recovery.

“Although there is a good deal of uncertainty about the pace of
those recoveries, as the expansions continue, central banks will
eventually need to tighten monetary conditions,” Plosser said. In past
speeches, he has made it clear he favors tightening earlier rather than

Relying on some estimation of how far economies are falling short
of their potential could miss the mark because “statistical measures of
output gaps or unemployment gaps could very well appear to remain quite
wide, even when increases in economic growth and the outlook for
inflation call for such tightening.”

“Explaining such decisions about the appropriate stance of monetary
policy will be challenging, and central bankers will need to communicate
with the public about these issues well in advance of their decisions to
ensure that their policy actions are not misunderstood,” he said.

All the better to rely on “simple” measures that can be more
easily communicated, he said in remarks prepared for the Czech National

The Taylor Rule and similar relationships between interest rates
and the economy relate to inflation and real activity but in fact relay
on variables that “are, in fact, poorly measured.”

The co-called output gap refers to the deviation of output from
some level deemed optimal, often called “potential output.” Likewise,
he continued, “the unemployment gap is the deviation of unemployment
from an unemployment rate that represents ‘full employment.’ But how
should we measure ‘potential output’ and ‘full employment?'” he asked.

However they are measures are not as solid as a reliance on
“systematic, rule-like behavior, in which the policy interest rate
responds to the deviation of inflation from a target,” he said.

“If the policy rule includes a measure of real activity, it is the
change in the level of activity or growth rate, rather than the output
gap or the unemployment gap,” and, he said, “a credible commitment by
policymakers to behave in a systematic, rule-like manner over time leads
to better economic outcomes than discretion.”

“It’s important that our policy rule be robust enough to work in a
variety of economic conditions or stages of the business cycle, that it
perform well in a variety of economic models, and that it recognize that
economic data are measured imprecisely and are subject to revision.”
Those criteria, he said, “lead me to support a rule based on deviations
of inflation from the policymakers’ inflation target and on the growth
rate of output, rather than on the output gap commonly used in many
variants of the well-known Taylor-rule.”

Plosser said research has shown that “data uncertainties are not
just theoretical curiosities. They have caused actual problems when
policy has been based on mismeasured gaps, resulting in unnecessary
economic instability.”

The Great Inflation of the 1970s, he said, had as a contributing
factor mismeasurment and “part of the problem appears to have been
caused by basing monetary policy on unemployment gaps.”

While over much of the 1970s, real-time estimates of the natural
rate of unemployment indicated that the economy was operating below its
full-employment potential, in fact, “the opposite was true. This
misperception led to an inflationary bias to policy, as policymakers
reacted to the mismeasured unemployment gap.”

In the mid to late 1990s, though, the Fed averted a large deflation
by “responding aggressively to deviations of inflation from a target and
to economic growth — not gaps,” he said. “Chairman Greenspan’s choice
not to base monetary policy on gaps had its precursor under the
leadership of William McChesney Martin.”

“Simple rules serve as a useful benchmark for setting monetary
policy,” he said. “They allow policymakers to be more systematic and
less discretionary in their approach to policy.”

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

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