Fed Member--End QE2, Maybe

Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia, would like the central bank to get out of the QE2 business as soon as possible. He offers a number of facts that do not support his conclusion:

To summarize, my preferred operating environment would re-establish the federal funds rate as the primary instrument of monetary policy; shrink the balance sheet and reserves to levels that make the federal funds rate an effective policy tool; and restructure the balance sheet in terms of its composition and maturity structure. Adopting an explicit inflation objective would contribute to the effectiveness of policy and the policy framework and any plan for normalization.

Plosser says that consumer spending has revived nicely, business investment borders on robustness and the labor market is awakening from three years of slumber.

It is a shame that the arguments for his views are so thin. Everyone wishes the economy would move back to 5% annual GDP growth and stay there for the rest of the decade.

The hurdles to reach a level of sustained growth are few, but high. The first is the tremendous pressure of inflation which has not reached the consumer for the most part but will. Increasing gasoline prices are only one example of this phenomena. People are paying $4 a gallon in some regions. West Texas crude is above $106, and Brent above $116.  There are almost no circumstance which would prevent gas prices from rising at least another 20 cents.

The other elements of inflation are better hidden, temporarily. Cotton, lumber, gold, coffee and wheat prices have all gone up by double digits this year. Retailers have already begun to pass these increases on to consumers. If this process works, consumers will have to spend much more money they do not have on each item they buy. If it does not work, companies will find margin compression will drive down profits or even create losses. Losses usually result in costs cuts and that often means layoffs.

Plosser has to make the case, which he cannot,that the European sovereign debt crisis means nothing to the US. He assumes that American banks and financial firms will not be hurt by the potential of renegotiation of  the principles of paper issued by Portugal and other nations in the regions–which is a real possibility. He assumes that demand for US goods will not be hurt in the EU if austerity measures and high taxes become wide-spread.

Plosser also has to make a strong case that the economy will replace the 500,000 jobs it lost per month during several months during the recession. Job replacement is barely 200,000 a month, and inflation could undermine that. The long-term unemployed have lost skills and the ability to move around the country to find new jobs. This is worsened because many people cannot afford to sell their homes.

If wishes were horses, all the beggars would ride.

Douglas A. McIntyre