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Plosser Says Fed Policy Guidance Risks Stoking Inflation

Federal Reserve Bank of Philadelphia President Charles Plosser said the Fed risks stoking inflation by providing guidance that only partly describes how the central bank will alter policy in response shifts in the economy.

“Forward guidance may risk unanchoring longer-term inflation expectations,” Plosser said today in the text of remarks prepared for a speech in Stanford, California. The Fed should identify “the key economic variables on which we base our policy decisions and then frame the rationale for any change in policy around changes in these key variables.”

The central bank in December linked the benchmark interest rate to economic indicators for the first time, pledging to hold rates near zero as long as unemployment is above 6.5 percent and projected inflation doesn’t exceed 2.5 percent. The Fed’s long-term inflation goal is 2 percent.

“In practice, with imperfect credibility, allowing inflation to deliberately deviate from the central bank’s longer-term goal runs the risk that inflation expectations will become unanchored,” Plosser said at Stanford University.

Since cutting its benchmark policy rate to near-zero in December 2008, the Fed has experimented with unprecedented tools to fuel economic growth and spur job creation. The Fed has used new communications to influence investor expectations for the duration of record accommodation.

Before its December decision, the Federal Open Market Committee said it expected to keep rates near zero through at least mid-2015.

The Fed’s current communications policy tied to thresholds for inflation and unemployment is insufficient because the central bank hasn’t said what it will do when the two benchmarks are crossed, Plosser said.

“While our models suggest that forward guidance is a useful policy tool, we must remain humble about its expected benefits in the real world of imperfect commitment, imperfect credibility, and difficult-to-manage expectations,” Plosser said. “The best course is to be clearer about what our reaction function will be to changes in key economic variables.”

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