Dr. Plosser recommends basing policy decisions on the state of the economy
Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke at the Council on Foreign Relations in New York on May 8, 2014. The topic for discussion was “Communication and Transparency in the Conduct of Monetary Policy.” In the last part, we discussed how market expectations with regard to the Fed funds rate and inflation can affect the various segments of the economy. In this part, we will discuss Dr. Plosser’s views on the use of systematic tools, for example, Taylor-like rules for setting policy rates and communicating these to markets.
Monetary policy decisions should be determined on a “reaction function,” that is, how the economy reacts to certain variables, based on which, the Fed funds rate would be determined. This reaction function should be described in the monetary policy guidance given to markets and central banks should clearly state the variables, which would determine the future path of the base rate. Although policymakers are subject to the same uncertainties as everyone else is and cannot be totally certain about specific future values of the Fed funds rate, a reaction function that describes the process of determining the base rate can provide better information to market participants.
Charles Plosser on the use systematic policy in the form of Taylor-like rules
“I place a great deal of importance on systematic behavior both as prescription for good policy and in terms of my own policy deliberations,” said Dr. Plosser. Taylor-like rules do a good job of approximating monetary policy in various theoretical settings and can provide useful guidance in the face of economic uncertainty.
What is the Taylor rule?
Stanford university economist, John Taylor developed the Taylor rule in 1992. The rule is used to forecast the level of nominal fed funds rate due to changes in key macroeconomic variables like inflation, output, etc. The output from the Taylor rule formula gives the nominal base rate. In summary, when the inflation rate in the economy is higher than the central bank’s target rate, the resultant base rate would also be higher, suggesting that monetary tightening in the economy, through higher base rates was required. In terms of other macroeconomic variables, if the GDP, for example, was lower than the full employment level supported by the economy, the Taylor rule formula would give a lower base rate, indicating that an accommodative monetary policy for the economy was in order.
To read more about the linkage between inflation and the Fed funds rate, read How firms’ inflation expectations impact the Fed’s mandate.
Which sectors perform best in inflationary and deflationary times?
During times of inflation, the basic materials and natural resources sectors are two of the sectors that generally perform better, as companies in these sectors find it easier to pass on cost increases to customers. One ETF that invests in natural resources stocks is the iShares North American Natural Resources ETF (IGE). Top 10 holdings in IGE include Chevron (CVX) and Anadarko Petroleum Corporation (APC).
The Treasury Inflation Protected Securities (or TIPS) also protect the value of debt securities from eroding due to inflation. Issued by the U.S. government, the par value of these securities increases with inflation. ETFs providing exposure to TIPS include the iShares TIP Bond ETF (TIP) and the SPDR DB International Government Inflation-Protected Bond ETF (WIP).
During times of deflation and when inflation is trending downward, fixed income securities tend to perform better, all else equal. Lower rates of inflation and deflationary prices indicate lower nominal rates of interest on fixed income securities. This raises prices of bonds, since bond prices increase with a decrease in interest rates.
In the next part, we will discuss Dr. Charles Plosser’s views on how the Fed can increase transparency in setting policy rates by providing well-designed and systematic communication.