–Until More Progress on Dual Mandate, Accommodative Police Appropriate

BOSTON (MNI) – The following is the text of the remarks of Boston
Federal Reserve Bank President Eric Rosengren prepared Wednesday for the
Massachusetts Chapter of NAIOP, the Commercial Real Estate Development
Association:

A Look Inside a Key Economic Debate: How Should Monetary Policy
Respond to Price Increases Driven by Supply Shocks?

I would like to thank David Begelfer and his colleagues at NAIOP
Massachusetts for inviting me to join you today to discuss the economy
and monetary policy.

I am happy that financial markets and the economy have made
significant progress since the depths of the financial crisis, but I am
far less happy that the recovery to date has been so undesirably slow
and anemic. In my reading of economic history this is, unfortunately,
typical of economic downturns that are accompanied by severe financial
disruptions.

The debate I’d like to focus on today is the one over the likely
impact of recent increases in the prices of food and energy, and how
monetary policy should respond. The Fed’s policy stance, as you know,
is currently very accommodative – a stance that I believe is appropriate
given the tentative recovery and still-high unemployment. But with food
and energy prices rising, some observers think the Fed should shift its
stance to less accommodation – slowing economic growth now to ensure we
don’t have undesirably high inflation in the future – even though
current measures of core inflation (that is, inflation omitting volatile
food and energy prices) remain low by historical standards.

As the recovery continues – albeit slowly – several events have
occurred that further complicate the outlook for inflation and real
economic activity. Political upheaval in the Middle East has contributed
to sharply higher oil prices. Severe weather has reduced harvests from
Russia to Australia, causing higher prices for many agricultural
products. And Japan’s tragic earthquake and tsunami caused not only
terrible loss of life, but also disruption to a supply chain that is
increasingly global.

So today I would like to discuss how monetary policy should react
when the economy is buffeted by a series of these so-called “supply
shocks.” I’d like to just highlight my major points before getting into
the data and analysis that underpin my perspective.

First, I want to explain that while I will be making distinctions
in this talk between socalled “core” and overall or total measures of
inflation, we at the Federal Reserve look at all prices, including food
and energy prices, when developing U.S. monetary policy. While we often
use core measures as a guide to where overall inflation is most likely
to go, our goal is to stabilize overall inflation.

Allow me to preview one of my conclusions. Because my analysis
suggests that recent food and oil price increases have their roots in
concerns about wheat harvests in Russia and oil production in Libya and
the like, I do not believe that monetary policy is the appropriate tool
to respond to these disruptions. While many observers see food and
energy prices rising and assume the Fed should tighten policy – raise
the cost of money and credit – to head off inflation, I would suggest
taking a step back and recognizing that tighter U.S. monetary policy
will do nothing to stabilize Libyan oil production, reduce uncertainty
about political stability in the rest of the Middle East, or increase
the wheat harvest in Russia.

In fact, tightening monetary policy solely in response to
contractionary supply shocks would likely make the impact of the shocks
worse for households and businesses. To see why this is so, it is
important to keep in mind how supply shocks affect the economy.1 First,
supply shocks can lead to increases in food and energy prices that slow
economic growth. For example, because a person’s need to drive may not
be very flexible, spending on gas consumes a bigger portion of their
budget. So an oil shock tends to force consumers to reduce their
spending on other goods and services as they absorb higher oil costs.2
Second, while the prices of goods directly affected by the supply
disruption increase, other prices in the marketplace may be unaffected –
at least initially. If the supply shock involves food or energy, this
dynamic causes measures of total inflation to rise, but does not have a
large impact on what economists call core inflation – which excludes the
volatile food and energy sectors. But in the longer-run, the impact of
the supply shock on the prices of other goods will depend importantly on
how inflation expectations respond to the shock. If people expect that
food and energy prices will stabilize – in other words, that the price
shock will be temporary – and do not believe that the central bank will
allow any long-run effect on inflation, then the disruption to total
inflation will likely be temporary and the total inflation rate will
eventually converge with the lower core inflation rate. Since 1986, this
has largely been what happened when we experienced these types of supply
shocks – as I’ll illustrate in a moment with some charts.

Alternatively, if expectations of inflation do rise in response to
the supply shock, then (nominal) wages and salaries across the economy
will be pressured to increase over time to keep pace. If that happens,
the supply shock could affect prices throughout the economy – not just
those that that were part of the initial supply shock. In this case, the
core rate of inflation rises to converge with the higher measure of
total inflation. This was the U.S. experience in the 1970s, for reasons
I’ll discuss in a moment.

We at the Fed need to very closely monitor the data to make sure
that inflation remains contained. And we will. But as I believe I will
demonstrate this morning, the most likely result is that these supply
shocks cause slower growth in the near term while having only a modest
effect on longer-term inflation rates – which has been the U.S.
experience since 1986. Unemployment remains quite elevated, at 8.8
percent, and I anticipate a slower return to full employment than we
would have experienced absent these supply shocks. With the core
inflation rate over the prior year at a little above 1 percent, I
anticipate only a gradual return of core and total inflation rates to
something like our consensus “stable” rate of about 2 percent, over the
medium term.

If the economic data continue to support this outlook then the
current, accommodative stance of monetary policy is appropriate, and can
remain in place and continue to support economic growth – so that we
continue to make progress toward our goals of returning to full
employment and a sustainable long-run inflation rate – the two elements
of the Federal Reserve’s dual mandate from Congress.

The Impact of Recent Supply Shocks

Now that you know my basic take on this key – and current –
economic debate, allow me to flesh out my perspective with the
supporting data and analysis. The full impact of the recent shocks to
supply that I mentioned at the outset will likely emerge over time. But
clearly there have been significant increases in a variety of food and
energy prices. As Figure 1 illustrates, the recent turmoil in the Middle
East has contributed to a significant increase in oil prices, which have
risen to over $100 a barrel. This is well above the average of nearly
$80 a barrel experienced over 2010, but at the same time still well
below the peak of $146 a barrel that occurred in mid July, 2008.

The recent volatility in oil prices, as the chart shows, is quite
striking. Sharp increases have been followed by sharp decreases. This is
one reason we may not want to overreact to price changes – they could be
transitory.

Figure 2 shows the movements in oil prices – their percent change
from a year earlier, in the top line – relative to the change in
compensation (the lower line), since 2000. Oil prices have risen
recently, but based on the history captured in this chart, one would not
expect much of a response in wages and salaries. This, of course, is one
reason why consumers feel worse off after an oil supply shock. Prices at
gas stations in Massachusetts are now around $4.00 a gallon, yet most
people’s need to drive cars has not changed much if at all. So income
available for buying other goods and services has been squeezed by the
increase in oil prices.3

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