–Fed Should Provide More Info About Its ‘Reaction Function’

By Brai Odion-Esene

WASHINGTON (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser Thursday called for the Fed to take additional steps to
improve the public’s understanding of the future path of monetary
policy, arguing that it would improve the effectiveness of policy and
lower uncertainty.

Specifically, Plosser advocated the adoption of a specific policy
rule or “reaction function” to guide the central bank, adding that it is
“feasible” that senior Fed officials could agree on a set of economic
variables to guide future policy.

“A better understanding of how policymakers will react to economic
events over time can reduce uncertainty about the expected path of the
short-term interest rate and so reduce the uncertainty and volatility of
long-term rates,” Plosser said in prepared remarks to the National
Economists Club in Washington.

Plosser will not be a voter on the Fed’s policymaking Federal Open
Market Committee until 2014. He does, however, sit on the Fed’s
communications committee.

“Reducing uncertainty about monetary policy, therefore, can help
anchor expectations, improve the effectiveness of monetary policy, and
reduce economic volatility,” he added.

Plosser has been an outspoken critic of the FOMC’s current
expectation that economic conditions will likely warrant interest rates
near zero until late 2014 — he believes a rate hike will be needed a
lot sooner — and in a veiled dig at the projection, he said: “A central
bank that is transparent will be less willing to make promises it cannot
keep. When policy pronouncements are more credible, policy is more

Therefore Plosser favors a systemic approach to monetary policy,
arguing that it is more transparent and easier to communicate.

“I believe the FOMC should continue to work toward increasing the
public’s understanding of how policy will react systematically to
changes in economic conditions,” he said.

“By systematic policy, I mean policy that functions in a rule-like
way,” he said, meaning a systematic relationship between changes in
economic conditions and the policy actions and choices made by the
central bank.

“I believe that the Fed should provide more information about its
reaction function and communicate its policy choices in terms of that
reaction function. It is not just about transparency. The practice of
using systematic rules as guides to monetary policy imposes an important
discipline on policymaking as well as improving communications and
transparency,” Plosser said.

He acknowledged that FOMC participants are probably not ready to
agree on a specific policy rule or reaction function “because they use
different models and have different loss functions.”

“In the meantime, it does seem feasible that participants could
agree on a set of economic variables to which monetary policy should
react,” Plosser added, with policymakers providing information about the
factors that will influence their policy decisions.

Plosser said the FOMC would not have to specify the precise
mathematical rule but would provide assessments of key variables and
then communicate policy decisions in terms of changes in these key

“If policy were changed, then we would explain that change in terms
of how the variables in our response function changed,” he said.

A noted inflation hawk, Plosser made clear what rules he would like
to steer monetary policy.

“The academic literature suggests using rules that respond
aggressively to deviations of inflation from the central bank’s target
and less aggressively to deviations of output from some concept of
“potential output,” he said.

Plosser also opined that the FOMC could improve its communication
and transparency by preparing a more comprehensive monetary policy
report on a regular basis, perhaps quarterly.

“Currently, the Chairman testifies before Congress twice a year and
submits an accompanying written report. In addition, the Chairman holds
press briefings four times a year to summarize the SEP. I think there is
an opportunity to combine these efforts into a more comprehensive report
on monetary policy as many other countries do,” he said.

Plosser said this enhanced report would offer an opportunity to
reinforce the underlying policy framework and how it relates to economic
conditions in addition to summarizing participants’ economic forecasts.

The overall goal, he argued, would be to remove any uncertainty
surrounding the likely future path of monetary policy.

“The better the public and the markets understand how policy is
likely to be adjusted as the economy changes, the more predictable
policy becomes, which promotes price stability and better economic
outcomes,” Plosser said.

** MNI Washington Bureau: 202-371-2121 **